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Introduction

Overview of Real Estate Securitization

III. Key Legal, Tax and Accounting Considerations in Real Estate Securitization

1. Legal Considerations

1) Bankruptcy Remoteness: Concept and Structural Necessity
As mentioned in the first section of this chapter one of the most basic requirements of the real estate securitization structure is to ensure that the entity is bankruptcy remote from the originator and any investors and vice versa. Thus the concept of bankruptcy remoteness is that even if an interested party of a securitization goes bankrupt, the cash flow of the securitized asset and thus the redemption of the principal and interest and any equity returns as defined at the inception of the securitization are not affected by the bankruptcy of the interested party as a result of the performance of the assets being based on the assets in the structure and the structure itself.

Securitization transfers the securitized asset from the originator and places it in a securitization vehicle which has a capital structure created based on the cash flows that the asset can generate. In principle the securitization is not dependent on the creditworthiness of the originator and so investors demand that any direct impact on the investors from bankruptcies of the originator or the vehicle itself be eliminated, this is referred to as being bankruptcy remote.

Bankruptcy remoteness is essential in an asset monetization securitization, which requires the stability of the securitization vehicle. The steps taken to ensure bankruptcy remoteness would include.

a. Legally separating the securitized asset from any influence of the bankruptcy of the originator; and

b. Minimizing the bankruptcy risk of the actual vehicle owning the asset subject to securitization (Tokutei Mokuteki Kaisha (TMKs) under the Asset Monetization Law, SPCs with the form of KKs and YKs, etc.).

2) Separation from Originators
If a securitization vehicle receives staffing or capital influences in its administration from the originator or equity investors the vehicle may become embroiled in bankruptcy proceedings if the originator were to go bankrupt. This may lead to the investors being treated as general creditors, which may disallow investors from receiving profit distributions or receive the redemption of principal and interest.

For this situation to occur the custodian appointed on bankruptcy of the originator would judge that the transfer of the asset was not a true sale (see 4) True Sale), but that it was the provision of collateral and thus deny the original transfer of the asset to the securitization vehicle. If this were to occur the collection of investment funds is only possible through reorganization collateral rights in relation to the corporate reorganization of the originator.

The following are considered when judging the bankruptcy remoteness of a securitization vehicle from its originator.

a. Rational intent of the interested parties as indicated by the contract.

b. Third party involvement in the securitization process

c. Appropriateness of the transfer price

d. Is the risk of the transaction appropriately assigned?

e. Is the transaction merely for accounting purposes?

f. Is the securitization vehicle independent? (Eliminate all aspects of control the originator may have over the securitization vehicle)

The last item on this list requires some technical aspects to be addressed and to achieve a bankruptcy remote structure Cayman SPCs with charitable trusts or Chukan Hojin are regularly utilized.

3) Minimizing the Risk of the Securitization Vehicle going Bankrupt
If a vehicle used in an asset monetization securitization filed for bankruptcy it would be impossible for the secured debt holders to seize the assets due to preservative order the court would place over the assets and thus the securitization structure would not function correctly. Thus, in addition to measures to prevent the bankruptcy of the vehicle additional measures should be taken to avoid the securitization vehicle filing for bankruptcy. Among the actions taken to prevent this are: i) the securitization vehicle (debtor) foregoes the right to file for bankruptcy through contract between the vehicle and investors, but most commonly the secured lender; ii) the selection of a director who is independent of the originator and other interested parties; and iii) requiring the approval of all directors to file for bankruptcy in the articles of incorporation.

However, the legal validity of these preventative measures have not been tested in the courts so cannot be 100% relied on yet.

4) True Sale
A key requirement to secure bankruptcy remoteness of a securitization vehicle is that a legally valid sale occurred when the asset is transferred from the originator to the securitization vehicle. If, for some reason, the sale is rejected legally the transaction is treated as a transfer of collateral. In such a case, if the originator goes bankrupt, the rights of the securitization vehicle to the transferred assets would become restricted and a default would potentially occur because the securitizations would not have free unfettered access to the cash flows from the assets thus the redemption of principal and interest according to its loan contracts would be no longer possible.

The judgment of whether a transaction is a collateral movement or a true sale is a legal judgment and can in practice lead to problems in the event of a bankruptcy therefore specific steps are taken that includes clearly stipulating the desire to sell and buy the asset to be securitized in the sales and purchase agreement and obtaining a legal opinion that quantifies the risk being borne by the originator after the transfer of the asset as well as that fair consideration was paid for the asset among other aspects.

When the 5% accounting rule prevents an asset from being moved off a balance sheet for accounting purposes there are many instances where a true sale is demonstrated through a legal opinion and adding an annotation to the balance sheet in which the asset is consolidated that the sale of the asset has been completed, however there remains a difference of opinion in the market over the validity of this process.

5) Defenses Against Third Party Claims
If defenses against third party claims are not in place at the time of transfer of the assets to be securitized and the originator goes bankrupt the bankruptcy custodian or other third parties may be able to make a valid claim against the assets.

To provide sufficient defense against third party claims in the ordinary transfer of assets requires a notice to be issued or the approval of the debtor that the asset being transferred is released from any claim and such approval should be provided in writing.

Designated monetary claims of corporations can have third party claims mitigated without the approval of the debtor by registering the credit transfer in the registry, this is a result of the “Law on the Exception to the Civil Code concerning Requirements Set Up Against the Transfer of Claims” (Special Credit Transfer Law) issued in conjunction with the SPC Law in 1998.

As it is impossible to meet the requirements against the debtor it is normally necessary to issue notices or complete other procedures to prevent the creditor from exercising any rights with regard to set off when the originator and debts were related in some fashion and where the creditor has rights of offset payments.

6) Bankruptcy of Servicers
When a servicer involved in the recovery debts that were previously attached to the assets transferred to the securitization vehicle goes bankrupt there is the risk that the funds collected by the servicer for the payment of third party debts that servicer was collecting are seized by the creditors of the servicer and that these funds become embroiled in the bankruptcy proceedings of the servicer. This risk that the funds recovered by the servicer for third party debts and the servicer’s own operating funds become mixed together is called commingling risk.

The most common methods for mitigating commingling risk are using separate dedicated accounts for the management of collected funds for third parties, reducing the period of time the servicer actually holds the funds in its accounts to a minimum and enhancing the credit of the servicer through posting of cash collateral, the use of bank guarantees, etc. There have been cases where back-up servicers have been used to recover funds in place of the original servicer when the original servicer is unable to perform these duties for some reason.

7) Bankruptcy Remote Vehicles - Analysis by Governing Law

a. Asset Monetization Law
(1) TMK
Asset monetization securitization requires the vehicle be bankruptcy remote, the basic requirements for this are as indicated above but it is necessary to eliminate any control the originator has over the vehicle and ensure the TMK is remote from any impact that the bankruptcy or any other actions of any other related party, such as those with voting rights in the general meeting of members, can have on the TMK. There are a number of structures for severing the relationship between the originator and the securitization vehicle which include the special interest trusts under the Asset Monetization Law and described in more detail below or charitable trusts or Chukan Hojin.

Among the methods for preventing the arbitrary termination of directors in the general meeting of the members of a TMK are limiting the legal voting rights of preferred equity members and/or using the articles of incorporation to prevent proposals by members to terminate directors.

(2) Special Purpose Trusts (SPTs)
The basic requirements for determining bankruptcy remoteness are the same whether a corporate structure or a trust is used, however the significant difference is that once a property is placed in trust it becomes the property of the trustee and is thus separated from the settlor (originator). Thus in a settlor directed trust where the settlor is also the beneficiary, even if the settlor/beneficiary interest holder goes bankrupt, the bankruptcy custodian merely succeeds the prior beneficiary the position of the as the beneficiary interest holder. The creditors to the trust receive priority in the payments from the trust property over the bankruptcy custodian that succeeded the position of the beneficiary.

b. Investment Trust Law
(1) Investment Corporation
The Investment Trust Law does not specifically address the bankruptcy remoteness of equity investors and investment corporations, however listed J-REITs and other REITs have created strong governance and high transparency in their management policy which reduces the possibility of bankruptcy to a level which is lower than ordinary joint stock corporations.

(2) Investment Trusts
Investment trusts, like the Tokutei Mokuteki Shintaku (TMS), achieves bankruptcy remoteness due to the nature of a trust.

c. Real Estate Syndication Act (TKs)
In the case of TK real estate syndications it is possible to separate partnership property as a TK account but there are no specific measures that assure bankruptcy remoteness when the operator goes bankrupt thus the rights of the TK investors are the same as ordinary creditors if the operator were to go bankrupt.

8) Bankruptcy Remote Structures
The three primary methods used ensure the relationship between the originator who is investing equity in the securitization vehicle and the securitization vehicle itself is severed are: 1) specific interest trusts, 2) Cayman SPC (TMK) + charitable trust and 3) Chukan Hojin. The most commonly used of these to date has been the Cayman SPC (TMK) + charitable trust, but recently there have been more cases of the Chukan Hojin being used. Although the specific interest trust is provided for in the Asset Monetization Law its actual use is still very limited.

a. Specific Interest Trust
The specific interest trust is a trust whose objective is to manage the interest related to specific investments in a TMK under the Asset Monetization Law so that the operations related to the monetization of assets based on the asset monetization plan may occur without interference. The law stipulates many aspects that allow the specific interest to be placed in trust with a trust company without the approval of a general meeting of shareholders. This prohibits the trust settlor from issuing instructions to the trustee and prevents the settlor or trustee from being able to terminate the trust during the trust period.

Use of a specific interest trust eliminates all influence of the originator of the TMK over the TMK and achieves the same as a Cayman SPC and charitable trusts. However there are still very few instances where the specific interest trust has been used because of doubts over the validity of the law that prevents the termination of the trust during the trust period.

b. Cayman SPC & Charitable Trust used in conjunction with a TMK
Charitable trusts, used in combination with a Cayman SPC (shareholder) and either a TMK or YK/KK as the securitization vehicle, are the most frequently used bankruptcy remote structures.

The Cayman SPC holds the equity interests with voting rights in the Japanese SPC (TMK or YK/KK) and is the 100% parent company of the domestic SPC and the Cayman SPC is owned in turn by a trust company for the benefit of the charitable trust. The trust company uses the trust pledge system to form a charitable trust with the shares it owns in the Cayman SPC and then concludes a contract that the residual property of the Cayman SPC, upon completion of the trust period, will be donated to a charitable body (charitable body designated the beneficiary interest holder). In this case, the trust company becomes both the trust settlor and trustee and by taking these steps a structure is created where there is no specific shareholder with voting rights in the Japanese SPC and so is bankruptcy remote.

Cayman SPCs are used because there is no minimum capital requirement in the Caymans and it is thus both inexpensive and easy to establish an SPC plus there are tax advantages.

c. Chukan Hojin
Chukan Hojin were recently devised to act as a bankruptcy remote structure to replace the Cayman SPC + charitable trust. The Chukan Hojin is based on the Chukan Hojin Law and its use reduces costs and enables a bankruptcy remote structure to be created entirely within Japan. It is expected that the Chukan Hojin will become more popular in Japan.

(1) Legal Definition of Chukan Hojin
The Chukan Hojin is defined in the Chukan Hojin Law as: “A corporate entity, established according to this Law, whose corporate objective is to seek the common interest of the members without distributing retained earnings to its members.”

There are two types of Chukan Hojin: limited liability Chukan Hojin and unlimited liability Chukan Hojin.

The members of a limited liability Chukan Hojin have voting rights but as the members have no obligation to contribute funds (equivalent to paid-in capital in a KK). Thus the limited liability Chukan Hojin has the characteristic where the investor in the Chukan Hojin (equivalent to a shareholder in a KK) and the holder of the voting rights (member) are not necessarily the same.

(2) Bankruptcy Remote Structure Using the Chukan Hojin
The basics for a bankruptcy remote structure using the Chukan Hojin utilizes the characteristic of a limited liability Chukan Hojin where the investor is not necessarily the holder of the voting rights. Even when the originator is the investor of the funds the originator is not made a member and thus the originator does not hold voting rights.

Bankruptcy remoteness from the originator is secured by having the equity interest that carries the voting rights of the SPC that owns the securitized asset acquired by the limited liability Chukan Hojin.

The specific structures are as follows:

Two or more individuals who are not directors or employees of the originator are appointed members of the limited liability Chukan Hojin. In general it is preferred that these members be lawyers or certified public accountants.
The originator invests funds in the limited liability Chukan Hojin.
The limited liability Chukan Hojin owns all the equity interests with voting rights in the securitization SPC that owns the asset being securitized thus making the SPC a 100% subsidiary of the limited liability Chukan Hojin.
In order to avoid the risk of the SPC filing for bankruptcy the directors and members of the limited liability Chukan Hojin conclude contracts with the SPC that eliminates their ability to file for bankruptcy.

(3) Merits of the Chukan Hojin
The merits of the bankruptcy remote structure utilizing the Chukan Hojin over the Cayman SPC structure are as follows:

As all of the establishment procedures for the limited liability Chukan Hojin can be completed in Japan there is no need to translate contracts into English.
There is no need for foreign exchange and procedures related to the Foreign Exchange and Foreign Trade Law.
Establishment and maintenance costs are reduced
Establishment period is shorter
Monitoring the Chukan Hojin during the securitization is more convenient

2. Tax Points

1) Double Taxation
The essence of real estate securitization is asset finance, which separates the securitized asset into the bankruptcy remote securitization vehicle that either owns the real property or is the beneficiary of a real estate beneficiary certificate. Figure 1-7 illustrates the tax concept of real estate securitization, the key issue is whether the securitization vehicle is taxable, and if so what is the impact on the securitization.

If the securitization vehicle is treated as a taxable entity it will recognize taxable income and corporation tax will be assessed. This will reduce the profits that are available to be distributed to investors and any distributed profits received by the investors will be taxed as income to the investors. From the perspective of the investor this “double taxation” is a poor result and if it may be avoided investment return will increase to the investor.

There are two primary methods for avoiding double taxation:

i. Use a securitization vehicle that is not taxed as a vehicle, i.e. a pass through entity, and

ii. Develop a structure where even if the vehicle is a taxable body the profits distributed to investors can be recorded as deductible expenses i.e. a pay through entity.

Figure 1-7 Outline of the Real Estate Securitization Tax System

*Click the image, large size is available

2) Conduit Requirements
The requirements of the tax system that need to be met to avoid double taxation plus meeting the bankruptcy remoteness requirements are known as conduit requirements for a given asset and securitization vehicles that satisfy these requirements called conduits.

Pass-through conduits include NKs, TKs and trusts while pay-through conduits include TMKs and TMSs under the Asset Monetization Law and investment corporations, investment trusts under the Investment Trust Law.

The following is an overview of the requirements of the respective conduits.

a. NKs under the Civil Code or Real Estate Syndication Act
An NK under the Civil Code can have multiple investors investing in common real estate interests be members of the NK through a contract to jointly operate the business. Unless a “group characteristic” that supersedes the individual members is recognized, the rights and obligations of the syndication are passed directly to the investors and tax is not imposed at the NK level so it acts as a pure pass through. The analysis holds for the NK under the Real Estate Syndication Act.

b. TKs under the Commercial Code or Real Estate Syndication Act
For a TK contract under the Commercial Code, the operator receives monetary investments from the third parties, those investors become members and the operator acquires the real estate to be securitized with the investment funds. Income from leasing or other operations and the resulting profits (or losses) are distributed to the members under the terms of the TK Agreement.

As the business is conducted in the name of the operator the TK is not taxed and the investors share of the profit or loss is recorded as a deductible expense of the operator and so is a pass-through structure. To create real estate securitization vehicles, YKs or KKs are combined with TK contracts to create pass-through entities for investors. TKs are treated in the same manner under the Real Estate Syndication Act.

c. Trusts
The “Principle of Taxation of the Beneficial Earner of Income” is regulated in Article 11 of the Corporation Tax Law and Article 12 of the Income Tax Law. Article 12 of the Corporation Tax Law and Article 13 of the Income Tax Law both prescribe similar regulations that apply the same principle with regard to trusts. According to this, when the beneficiary is specified the beneficiary is treated as if the trust property where directly held by the beneficiary and thus the trust is not recognized as a taxable body under the tax laws and acts as a pass-through entity.

However, under the investment trust system regulated in the Investment Trust Law that will be described later in more detail, a TMS that uses a trust as its structure is a taxable body for the purposes of corporation tax unless certain requirements are met and thus acts as a pay-through entity.

d. TMKs and TMSs under the Asset Monetization Law
In both cases the corporation tax is assessed but when certain requirements are satisfied dividends paid to preferred security holders are recorded as deductible expenses. The specific regulation requires that more than 90% of income that can be paid as dividends is paid as dividends (see Chapter 3 II for details). However, it is important to note that the payment of principal on corporate bonds and other debts are not treated as expenses so if expenses are rejected after settlement and the dividend requirement is not satisfied then corporation tax will be assessed on the securitization entity.

e. Investment Corporations and Investment Trusts under the Investment Trust Law
As with TMKs and TMSs described in d., in principal corporation taxes are assessed but when certain requirements are fulfilled, including the distribution of more than 90% of the net profit is as dividends, the dividends paid to investors are recorded as a deductible expense (see Chapter 3 III for details). The repayment of principal on debt is not an expense and so if the dividend requirement of distributing more than 90% of net profits is not met after settlement corporation taxes will be assessed on the entity.

3) KKs and YKs in Other Situations
When the Asset Monetization Law and Investment Trust Law regulate vehicles that satisfy the conduit requirements of a collective investment structure there is no particular method to avoid double taxation when KKs or YKs are used as they are seen as ordinary business corporations. In practice, when KKs, YKs or other vehicles are used as SPCs, a pay-through structure is created by using TK agreements that make the KK or YK the operator of the TK and the investor the TK member, and profits are distributed through the TK Agreement.

3. Accounting Considerations

1) Requirements for Moving Assets Off Balance Sheet
One of the merits of asset monetization of real estate is that the real estate that is securitized allows the originator to move the property off its balance sheet, but certain requirements must be met for the asset to be successfully transferred off balance sheet. A property can only be moved off the balance sheet of the originator and the capital gains or losses recorded when accounting rules recognize the transaction as a true sale and purchase. Conversely, when it is recognized that the originator continues to own and control the property despite utilizing a property transfer transaction, for accounting purposes the transaction is not recognized as the transfer of property but is accounted for a financing secured with real estate.

The guidelines for recognizing if a property has been successfully moved off balance sheet are detailed in the “Practical Guidelines on the Accounting of the Transferring Party in Real Estate Monetization Using TMKs” (prepared and issued by the Japanese Institute of Certified Public Accountants in July 2000). These Guidelines are generally referred to among practitioners as the “SPC 5% Rule” and “Practical Guidelines.”

2) Important Elements from the Practical Guidelines on Real Estate Monetization
The Practical Guidelines are described in detail in Chapter 3, but the following lists important practical elements from the Practical Guidelines.

a. The Practical Guidelines cover the asset monetization structure and not the asset management structure. In other words, it only applies to TMKs and equivalent vehicles (the SPVs) under the Asset Monetization Law.

b. The Practical Guidelines are exclusively concerned with the accounting treatment of the transfer of real estate to TMKs and do not necessarily apply to the tax accounting for the transaction. Thus there are cases where the sale is not recognized for accounting purposes but capital gains are recognized for tax purposes.

c. The Practical Guidelines designate the accounting treatment when the originator transfers existing real estate it owns to a TMK. Therefore, it is not applicable when a TMK acquires real estate from a third party. Hence it does not cover development securitizations where a TMK acquires newly developed real estate however the issue of consolidated or non-consolidated treatment does emerge with the company that is the investor in the TMK.

d. The Practical Guidelines state that the sales treatment of real estate is the following for a true sale (page 10): “Moving the concerned real estate off the balance sheet is recognized when almost all of the risk and the economic value related to the transferred asset are transferred to another party” (risk and economic value approach). Conversely, the interpretation can arise that when the transfer off balance sheet is not recognized then the sale (transfer) of the real estate is not recognized and in this case it will be treated as a financing transaction secured by the asset.

e. “Almost all of the risk and economic value has been transferred to another party'” is deemed to be achieved when the portion of risk borne by the originator of transactions is “generally within 5%.” “Generally” allows for a certain degree of latitude and discretion; however, caution is needed in the situations where this risk rises over time.

f. When the originator continues to be involved in the real estate even after its has been transferred there is the possibility that it will be deemed that the economic risk and economic value have not been transferred to a third party. In the case of a sale and leaseback that is frequently seen in monetization, continual involvement is not recognized when the lease agreement is an operating lease transaction and the paid rents are market prices.

g. When the contract allows for the originator to purchase the transferred asset at some point in the future, the sale of the real estate will not be recognized and it will be treated as a financial transaction. Further, if it is difficult to sell the subject real estate in the market to a third party in “as is” condition or other special conditions exist, a sale will not be recognized for accounting purposes.

contents

Basic Structure of Real Estate Securitization
Framework of Real Estate Securitization
Key Legal, Tax and Accounting Considerations in Real Estate Securitization
Significance of Real Estate Securitization
History of Real Estate Securitization
Market Size

“For more information on the English version of the Real Estate Securitization Handbook.”