Legal Update

Spring 2006

• ECJ WELCOMES REAL ESTATE PARTNER
• COMMERCIAL MORTGAGE LOAN CONDUIT - DEFEASANCE
• PARTNER PROFILE
• WHY THE GOOGLE SUBPOENAS MATTER TO YOUR BUSINESS
• ECJ ANNOUNCES NEW PARTNER

ECJ Welcomes Real Estate Partner

Samuel R. Spira

ECJ is pleased to welcome its newest partner Samuel R. Spira.

Samuel is a partner in ECJ’s Real Estate Department, and his areas of practice include transactions in the corporate finance and real estate industries. Prior to joining Ervin, Cohen & Jessup, Samuel was a partner at Gorry Meyer & Rudd, where his practice focused on transactions in the corporate finance, real estate and healthcare fields.

Samuel has extensive experience in numerous aspects of the development, ownership, management and disposition of real estate. In the corporate arena, he has expertise in the representation of acquiring and selling companies in negotiated transactions, representation of corporate lenders and borrowers in connection with secured and unsecured credit facilities and the representation of corporate participants in joint ventures and other contractual arrangements.

Commercial Mortgage Loan Conduit - Defeasance

By Samuel R. Spira

Many clients inquire about financing their real estate projects in the “conduit loan” market. There are a number of lenders in this marketplace providing an assortment of typically aggressive rates. While at first glance this category of loans may appear to be quite favorable, before deciding to proceed, it is advisable to review a short history of the procedure in connection with the eventual repayment of such loans through defeasance (as discussed below).

A Short Defeasance History

Defeasance first became a part of the commercial mortgagebacked securities (“CMBS”)¹   world during the early 1990’s as a mechanism to make pricing on CMBS more favorable, and has now become a nearly permanent fixture in the CMBS industry. Defeasance eliminates the prepayment risk associated with fixed-rate loans by providing an alternative mechanism under which the borrower can obtain a release of the lien of the mortgage securing the loan (to accommodate a sale or refinance of the real estate collateral) by delivering government securities as substitute collateral for the loan. This is based upon the premise that certificate holders of securities backed by securitized loans want predictable and uninterrupted cash flow. Prepayments, whether voluntary or involuntary, disrupt this cash flow. To address the interests of certificate holders in receiving a predictable and continuing cash flow, virtually all CMBS loans typically prohibit a borrower’s prepayment of a loan prior to the expiration of a specified “lock-out” period. In the CMBS market, this lock-out period typically extends until the last 60-90 days of the loan term. Defeasance is a means to balance the effect of the loan’s lock-out provisions against the borrower’s need to obtain a release of the REMIC trust’s lien on the related collateral (as may be the case in a refinancing or sale of the collateral).

What Is Defeasance?

Defeasance is the substitution of one type of collateral for another. In the CMBS industry, defeasance is the process by which the real estate and related collateral securing a mortgage loan are replaced by government securities in order to release the original collateral while keeping intact the payment stream for the mortgage loan. In a defeasance, the original loan continues to be held by the REMIC trust.²  The government securities that replace the real estate collateral are modeled so that the income stream from those securities replicates the remaining payments due under the terms of the loan. It is important to remember that the loan obligation is not cancelled when defeasance occurs, as would normally occur with a prepayment. Instead, the note and loan remain in full force and effect through the maturity date, with the payments under the loan being paid as the government securities are redeemed. In addition, defeasance is favorable to certificate holders carrying certificates backed by securitized loans because the opportunity for a borrower to default following a defeasance is significantly reduced (thereby avoiding the risk of early payment due to acceleration of the loan).³

Additional Cost Issues

In addition to the foregoing, conduit loans commonly carry some additional requirements that can create additional expense to a borrower. In particular, CMBS defeasance transactions are governed by New York law, so a New York perfection opinion issued by a law firm (often the loan servicer’s counsel) is required by the loan servicer. The NY perfection opinion letter confirms that the REMIC trust has a perfected security interest (by possession and control under Article 8 of the UCC) in the government securities that serve as the pledged collateral.

Further, conduit loans often require credit-worthiness ratings by rating agencies. Rating agencies are private companies that rate the credit-worthiness of bonds. The three best-known rating agencies are Moody’s Investors Services, Standard and Poor’s and Fitch ICBA. Typically, at least two of the three major statistical rating agencies rate the bonds issued to investors by a REMIC trust. Because defeasances can create issues that could cause the REMIC trust to lose its tax status as a REMIC, the rating agencies review the defeasance documents for certain large loans that meet the criteria established by them for rating agency review. The fee charged by a rating agency for its review of a defeased loan is typically paid by the borrower.

In addition, CMBS defeasance transactions must be completed in compliance with REMIC regulations, so, following securitization, a REMIC opinion issued by a law firm (often the loan servicer ’s counsel) is required by the loan servicer. The REMIC opinion letter confirms that the defeasance, as structured and documented, will not cause the REMIC trust to lose its status as a REMIC.

Conclusion

Conduit loans typically offer more aggressive rates for real estate investor/borrowers; however, these aggressive rates come at a sometimes hidden price. In an effort to meet the demands of the CMBS marketplace, real estate investor/borrowers are subject to substantially less flexibility, additional costs and more procedural hurdles to accomplish repayment. Prior to proceeding with conduit loan financing, it is advisable to consider much of the foregoing.

Partner Profile

By Karina B. Sterman

Karina B. Sterman is a partner in the Litigation and Employment Law Departments of ECJ. Her areas of practice include general business litigation, as well as a focus on representing employers in all types of employment-related matters, including counseling on wage and hour and other employment law compliance, drafting employee policy manuals and other employment-related documents and representing and advising employers in litigation and administrative proceedings.

Karina has served as an appointed member of the Executive Committee of the LACBA Barristers and as a program coordinator for the annual LACBA Nuts and Bolts of Civil Litigation series. She was also an elected member on the Board of Governors of the California Women Lawyers representing California’s District 7: Los Angeles, and as a volunteer for the Los Angeles County Domestic Violence Project. Karina has a Martindale-Hubbell peer review rating of “AV” (standing for “A” grade and Veritas, meaning very high professional ethics) and has been named a “Rising Star” in Employment Law by Los Angeles magazine for the past two years.

Karina is the co-author of Civil Procedure: High Court Case Summaries, published by West Group, and a contributor to the Los Angeles Lawyer magazine. She is also a contributing author of ECJ’S monthly newsletter, the Employment Law Reporter, and is a frequent  speaker on employment law issues to various prestigious organizations throughout the Los Angeles area, including Professionals In Human Resources Association (PIHRA), the Service Corps of Retired Executives (SCORE) and Los Angeles County Bar Association(LACBA).

Karina received her JD in 1997 from the University of Southern California, where she was on the staff of the Review of Law and Women’s Studies Journal. She graduated magna cum laude and Phi Beta Kappa in 1993 from the University of California Los Angeles with a Bachelor’s degree in English Literature and a minor in Women’s Studies.

Karina was born in the former Soviet Union, has moved around extensively and now resides in West Los Angeles with her husband Josh Goode (a history professor at Occidental College), their son, Milo, age 4 (who attends pre-school at Temple Emmanuel), and daughter, Anabel, age 1 (who is tired of being mistaken for a boy).

In Karina’s rare spare time, she enjoys cooking, traveling and pretending she knows how to fix things around the house. One of her life’s goals is to read an entire New Yorker magazine from cover to cover before the next issue arrives!

Why The Google Subpoenas Matter To Your Business

By John M. Houkom

Since late January 2006, there has been a buzz about the federal government’s efforts to access information related to searches done by anyone through the Internet company Google’s search engine. The U.S. Department of Justice issued several subpoenas to Internet Service Providers (“ISPs”) seeking a massive amount of information regarding how the Internet is used. The request to Google included information regarding all websites available from Google’s search engine, as well as all searches done over a specific time period.

The other major ISPs — AOL, Microsoft and Yahoo! — complied with their subpoenas. Google, however, did not, citing as its reasons for refusal both the risk of exposing proprietary trade secrets and the burdensome nature of the requests. The courts have not yet ruled as to whether these objections will relieve Google from having to produce the requested information, but the Supreme Court just recently indicated that it may enforce a slimmed-down version of the original information request. Regardless of the ultimate resolution of that conflict, it is very instructive, and along with  the general reminder to all Internet users that you should “be careful what you search for,” businesses should learn a very important lesson: establishing and following a document retention policy can protect the assets of your business and your customers’ privacy.

One of the reasons Google is in this fix is that it has not made a concerted effort to create a document protection policy that directs the planned destruction of information, and all of the information Google has ever compiled still sits in some repository, waiting for someone to subpoena those records.

What Should Be Retained Under A Document Retention Policy

Developing a comprehensive document retention policy – and following it – is often overlooked. It is the only way to ensure that a business both complies with its legal obligations and protects its interests and its clients’ interests to the best of its ability. Through proper application, you can avoid unnecessary costs while actually increasing efficiency and maximizing business assets.

The development of a comprehensive policy for document destruction and retention should include a survey of all information that is at a company’s disposal. It is only then that you can begin to identify which documents need to be retained. Failing to take this step can lead to unintentional retention of large amounts of unidentified information that can neither be used for commercial benefit nor vetted prior to any disclosure requests.

The information will be unique to each company and will often include information that has not even been considered in the past. In addition to the obvious categories – client lists, vendor lists, supplier information, correspondence – the birth of the digital age has  greatly expanded the information at a company’s disposal and the information that is subject to disclosure. For example, the sheer volume of email that is now pervasive in almost every company opens a whole new category of information that is only retained electronically, and information that will be retained indefinitely on the company’s servers unless it is systematically removed as part of a comprehensive document retention policy.

Companies must also look beyond the information they think is important and realize that their policies should cover all of the information in their possession. For example, companies will often overlook information related to their employees, including personal and private information gleaned from their employment. It is important that things like employee information are included in the retention policy, so that all privacy concerns can be considered.

Once the universe of information has been identified, the business must then determine how and where to retain those documents. Traditionally, most companies have not made an effort to compile and organize information that is not used during the normal course of its business. While customer information may be used every day, past ordering or payment histories and similar documents are more likely to end up in an unremarkable file, or in a box behind someone’s desk. It can be much more efficient to store all of the documents in a single location.

Documents and information produced by a company are often voluminous and will require some sort of dedicated storage. The additional cost may be offset by the greatly increased efficiency that can be achieved if that information is actually sought at a later date. The purpose of keeping all of the information at a single location is to make production and recovery more efficient, and also to ensure that any document requests can be responded to with a complete production, rather than a piecemeal process that can lead to the duplication of effort and even the inability to track down all of the required information when it is actually needed.

Most documents can also be stored electronically, which can lead to lower storage costs and the ability to search the documents for relevant information without actually physically looking at each piece of paper. The cost of scanning documents should be considered, but electronic retention will become more costefficient in the future.

Below are some of the legal issues to be weighed when designing the retention policy, but these need to be harmonized with the physical realities of a company’s business. The design and implementation of the policy should be undertaken with the advice of an attorney, who not only may be able to provide an analysis of the legal requirements, but may also be able to suggest practical solutions to retention issues and provide insight into the types of documents and information worthy of protection that would not occur to the company itself.

How Long Should The Information Be Retained

A assessment must be done to determine how long the information should be retained. That decision will be based on the legal obligations of the company and on any other business interests impacted by the policy.

A myriad of overlapping government regulations and requirements govern different industries. Many regulated industries, such as banking and lending, place obligations on companies to retain specific types of information, or to retain information for a specified period of time. It is only by consulting with an attorney that you can be sure that those legal obligations have been fully identified and integrated
into the document retention program.

The first step is to understand the varied compliance obligations. Different federal agencies require different retention periods. For example, under the Sarbanes- Oxley Act of 2002, public companies are required to retain records relevant to the audit of financial statements or review of SEC reports for seven years. On the other hand, the Immigration Reform and Control Act of 1986 requires only the retention of information verifying the employee’s right to work in this country for three years after the hire date, or one year after the termination of the employment, whichever is later.

These are just two examples of the varied federal retention requirements. Additional and diverse retention periods are also prescribed in numerous other federal statutes and regulations like the Health Insurance Portability and Accountability Act of 1996 (six years), the Occupational Safety and Health Act (five years) and the Age Discrimination in Employment Act of 1967 (three years). There are simply so many distinct retention obligations that an attorney’s advice is necessary to avoid inadvertently violating these standards.

Moreover, state and industry specific retention obligations must be considered. For example, contractors of a certain size are required to retain employment records for two years under the Department of Labor’s Office of Federal Contract Compliance Program’s executive orders. On the other hand, under the Fair and Accurate Credit Transactions Act, companies are required to dispose of certain consumer information to preserve the confidential nature of that information.

In addition to preserving information for business purposes, a company has a legal obligation not to destroy information relevant to a present or anticipated legal proceeding. Destroying that type of information can have very bad results, in that a court may order that the
jury presume that all of the destroyed documents were unfavorable to the party that destroyed them. However, documents destroyed in the normal course of the document retention plan, where there was no reason to believe litigation was upcoming, will not lead to that presumption.

Further, if a business believes that it may have claims in future litigation, it is in its best interest to preserve all of its relevant records, at least until the statute of limitations on any such claims has passed. Again, consultation with an attorney may be necessary to determine both the efficacy of the potential suit and the proper retention period for those documents.

Conclusion

The question of how long to retain information is not a simple one, and the overlapping legal obligations should be analyzed by a professional, both when the policy is designed and when any questions about its applicability are raised. In this circumstance, an ounce of prevention can be more valuable than pounds and pounds of cure.

If there is anything to be learned from the Google conflict, it is that retaining information can either benefit your business or weigh it down. Only through the adoption of a comprehensive document retention policy can a business take control of the situation, meet its legal obligations and act for the best of the company and its clients.

ECJ Announces New Partner

We are pleased to announce that Richard R. Cipra has been made a partner of the firm. 

Mr. Cipra is a partner in ECJ’S Real Estate and Business and Corporate Law Departments, focusing on a broad range of commercial real estate and business matters, including real property purchase and sale transactions, commercial leasing and mergers and acquisitions.

¹  CMBS is an abbreviation for “Commercial Mortgage-Backed Securities.” Loans for which the lender’s exit strategy is securitization by transfer of a pool of loans to a Real Estate Mortgage Investment Conduit (“REMIC”) trust are often referred to interchangeably as “CMBS loans” and “conduit loans.” A conduit loan is the same as a CMBS loan. The word “conduit” in this context refers to the pass-through tax status of the REMIC trust to which the lender intends to transfer the loan in a securitization.

²  When mortgage loans are securitized in the CMBS industry, they are put into REMICs, which are governed by complex tax regulations. A REMIC generally retains its tax-free status only if it holds “qualified mortgages” and “permitted investments.” A REMIC trust is the entity to which a lender transfers its loans when it securitizes them. There are a number of complex regulations in the U.S. Tax Code that govern the creation and maintenance of a REMIC trust. REMIC trusts issue bonds to institutional investors that are backed by commercial mortgages or other assets.

³  Default risk is reduced because the lender holds government securities which the borrower has no right to sell or liquidate and which make the loan payments directly.

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