Over the past two years, Merrill Lynch has pioneered the use of Canadian commercial mortgage-backed securities (CMBS) transactions, completing two such issues and nearing closure of a third in April, 2000.
The first of these was Merrill Lynch Mortgage Loans Inc. Commercial Mortgage Pass-Through Certificates Series 1998-Canada 1, valued at $163,874,000. The initial private placement for this series was done on December 21, 1998. The issue was subsequently done as a public distribution pursuant to prospectus on May 31, 1999. Douglas Klaassen, James Archer, David Rounthwaite and Ronald Schwass of McCarthy Tétrault represented Merrill Lynch on the origination of the commercial loans, establishing the mortgage conduit, the private placement, and the issuance of the publicly traded certificates. US Counsel to Merrill Lynch was Tom French of Wilkie. John Patterson of McMillan Binch was corporate counsel to the seller and issuer, Merrill Lynch, and Holly Robertson of McMillan Binch acted for GE Capital Loan Services Inc. as the Master Servicer.
Rose Bailey of Torys acted for Hudson Advisors as Special Servicer.
The second transaction was Merrill Lynch Mortgage Loans Inc. Commercial Mortgage Pass-Through Certificates Series 1999-Canada 2, valued at $193,741,000. This issue was done as a public offering on September 16, 1999. David Rounthwaite, Donald Klaassen and Adam Slater of McCarthy Tétrault acted for Merrill Lynch in the origination of the mortgage loans, establishing the mortgage conduit and the issuance of the publicly traded certificates. John Patterson of McMillan Binch acted as corporate counsel to Merrill Lynch. Holly Robertson of McMillan Binch acted for GE Capital Loan Services Inc. as Master Servicer.
The success of these transactions is a promising first step in the development of an active CMBS market in Canada. With the emergence of this market, we are just beginning to see its potential impact on Canadian mortgage loan origination and servicing practices.
The following is a brief review by Douglas Klaassen of McCarthy Tétrault of some of the legal issues which CMBS issuers, servicers, and originators can expect in a typical Canadian transaction:
Canada does not have a special set of income tax rules governing CMBS transactions similar to the US real estate mortgage investment conduit (REMIC) rules that permit the creation of mortgaged-backed securities by an issuer without attracting entity level tax. Accordingly, income and capital tax considerations at the issuer level are a primary concern in the structuring of a Canadian CMBS transaction.
The most common structure used in Canadian securitization transactions involves the sale of the financial assets to a special purpose trust, which in turn issues asset-backed debt obligations. Unlike corporations, the use of a trust does not generally attract provincial capital tax or federal large corporations tax. However, like a corporation, a trust is a taxpayer in Canada. As a result, the timing and matching of revenues and expenses of the trust becomes critical to avoiding issuer-level income tax, and in certain pass-through distribution waterfalls, the trust structure is not the most efficient from an income tax perspective.
An alternative structure involves the sale of securities representing undivided co-ownership interests directly in the financial assets. In this structure, the issuer, upon acquiring the commercial mortgages from the seller, immediately resells undivided co-ownership interests in the commercial mortgage pool to investors. A custodian holds registered title to the commercial mortgages, each investor acquires a direct property right in the commercial mortgage pool, and the rights and entitlements of the co-owners to distributions are established by agreement. This structure avoids income and capital tax at the issuer level because the issuer retains no interest in the mortgage loans following the issuance of the securities. The two Merrill Lynch CMBS transactions were based on this structure.
A second tax issue which must be addressed when structuring a CMBS transaction is Canadian withholding tax, which applies at a rate of 25 per cent (unless reduced by treaty) to interest payable by a resident of Canada (i.e., an issuer of asset-backed debt obligations) to a nonresident investor. Withholding tax is a significant issue for Canadian CMBS issuers where any of the investors in the securities are resident outside of Canada. There are a number of available exemptions to Canadian withholding tax, but they may not be available in many CMBS structures.
Each of the three Canadian CMBS transactions mentioned above has been qualified by prospectus in accordance with applicable provincial securities laws. Initial access to the public capital markets and the creation of a liquid secondary market in mortgaged-backed securities has been an important feature of the US CMBS market and a similar approach has been followed in Canada to date. Merrill Lynch Mortgage Loans Inc. recently received orders from Canadian Securities regulators to permit it to use shelf prospectus and short form offering procedures in connection with CMBS transactions. These steps have significantly enhanced the ability of this issuer to gain access to Canadian public capital markets without the substantial delay and cost of qualifying mortgage-backed securities under long form prospectus disclosure procedures and requirements.
Mortgage Broker Legislation
Several significant CMBS issues arise from the application of provincial mortgage broker, collection agency, and other comparable laws (collectively, “mortgage broker legislation”). One issue is whether the securitization of the mortgage pool constitutes either “dealing” or “carrying on the business of dealing” in mortgages, which is regulated by mortgage broker legislation in some provinces. Another issue is whether all or any of the originator, seller, issuer, master servicers, special servicer, and subservicers are subject to registration and other regulatory requirements of mortgage broker legislation in certain provinces. Both the scope of the mortgage broker legislation and available exemptions under this legislation differ materially from province to province. Some (but not all) provinces provide exemptions where the trade or dealer is regulated by applicable securities legislation. Legal opinions confirming compliance with applicable mortgage broker legislation by the originator, seller, issuer, master servicer, special servicer, and subservicers are a requirement of a Canadian CMBS transaction, and each of these issues must be reviewed and settled early in the transaction, and preferably, at the outset of the origination program.
Loan Origination Issues
There are a number of issues associated with the origination of Canadian commercial mortgage loans for a CMBS program which deserve attention:
Defeasance: Defeasance is new to Canadian conventional mortgage lending and the typical Canadian borrower and its counsel have little or no experience with the relative advantages and disadvantages of defeasance over lockout periods/prepayment options. To date, the mortgage market appears to offer little or no resistance to the standard defeasance provision.
Subordinated Debt: Restrictions on subordinated debt found in most CMBS programs are not common in the Canadian marketplace. The subordinate lender will usually resist the requirement that it “standstill” in exercising its mortgage remedies if the borrower defaults under the subordinate loan. This issue frequently creates difficulties for the mortgage loan originator in closing the transaction, even where the standstill requirement is clearly understood by the borrower.
Title Insurance: It is still quite common for the conventional Canadian mortgage lender to accept a title opinion from borrower’s counsel, and the title insurance is often perceived by the borrower as an unnecessary additional expense. Although rating agencies have accepted title opinions for Canadian CMBS transactions, title insurance is gaining increasing acceptance with both mortgage loan originators and borrowers for a number of reasons. In many cases, the title insurance premium is equal to or less than the cost of the lender’s title due diligence. Quality of title opinions can be uneven depending on the law firm involved. Title insurance is easier to manage in high volume CMBS programs and offers certain endorsements which can facilitate a quicker closing than most transactions which depend on title opinions.
Canadian Loan Documents: The next step in Canadian CMBS mortgage origination will be the use of standard Canadian conventional mortgage loan documents for future CMBS transactions, as opposed to “Canadianized” US documents that established conduit lenders and rating agencies have developed, approved, and used in US CMBS transactions.