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This article was first published on Lexis®PSL Banking & Finance on 30 April 2014. Click here for a free trial of Lexis®PSL.
30/04/2014
Banking & Finance analysis: As the European real estate market continues to see an influx of US investors offering much needed liquidity, Andrew V Petersen, partner at K&L Gates LLP, and Juliette C
Challenger, associate at K&L Gates LLP, consider the key elements of the US concepts of defeasance and yield maintenance and the emergence of these concepts in the European commercial mortgage market.
The last two years have seen an increasing number of US investors enter into the European commercial mortgage market. A buoyant commercial mortgage market, and a diversification of lenders offering funding, has increased availability of liquidity, which has led to US capital flowing into the UK and European senior and mezzanine debt markets. The turmoil in European banks as a result of the recent Eurozone crisis, the lack of liquidity in the European market, and the infancy of lending by alternative lenders in the UK and
Europe, such as debt funds and insurers, as compared with their US counterparts, has seen borrowers keen to take advantage of this capital influx from the US.
Prepayment fees have always been an essential element of US loans as a way of preserving the yield on the loan and, in relation to securitised loans, providing a predictable cash flow stream from the underlying loan.
In the US, prepayment fees are included in one of three ways: o o o declining balance formula (ie a fixed percentage of the loan balance is paid on the outstanding loan balance, such percentage reducing as during the life of the facility) yield maintenance formula, and defeasance
The intent of both defeasance and yield maintenance provisions in loan documentation is to protect against prepayment and to allow lenders to realise the same yield as if the borrower had held the loan to maturity.
Defeasance and yield maintenance achieve the same objective, in that the underlying real estate asset is unencumbered, but they are fundamentally different from a legal perspective.
The European commercial real estate market has, in contrast to its US counterpart, evolved without the practice of defeasance or yield maintenance. However, with a number of US entrants into the European commercial real estate market, there has been the introduction of such requirements in commercial real estate loans.
Defeasance provides an alternative prepayment mechanism and comprises three elements:

Page 2 o o o the substitution of acceptable replacement collateral, usually US government securities, gilts or other sovereign bonds, specifically selected to generate sufficient cash to make all monthly payments due throughout the life of the loan and at maturity, for the property collateral underlying commercial real estate loans--ideally, the portfolio of securities chosen will be structured so that each of the securities matures on or before a scheduled payment date under the loan, and the proceeds from the maturity of each of the securities are used to make the monthly payments due under the loan the assumption of the loan by a special purpose vehicle, therefore keeping the debt obligation alive as the loan remains outstanding for its full term, and the discharge of the mortgage from the property enabling the borrower to sell or refinance the property as it wishes
The defeasance process is managed by a specialist defeasance consultant who will select and purchase the correct qualifying substitution securities for the portfolio that will generate sufficient cashflow to meet the payment obligations under the loan until maturity, and deliver the securities to the securities intermediary.
The securities intermediary serves as custodian of the securities, and will be responsible for making monthly payments in connection with the loan from proceeds of the securities.
The borrower purchases the securities and pledges these in favour of the lender in exchange for releasing the security over the real property securing the loan. The securities will be held by the securities intermediary in a segregated account in the name of the borrower, for the benefit of the lender.
Simultaneously, the borrower assigns the loan and the substitution securities to a successor borrower, typically a newly created insolvency remote special purpose vehicle, which assumes all of the obligations and liabilities of the existing borrower under the loan and defeasance documents. Once transferred to the successor borrower, the original borrower is released from its obligations under the loan.
The defeasance process typically takes 30 days to complete (a 30-day minimum notice period is typical), although timing will depend on the complexity and deal volume of each transaction.
In certain circumstances, approval from the rating agencies will be required to ensure that the substitution of the securities will not result in a downgrade of the existing securities. Tax advice is also required to ensure that the defeasance transaction does not breach any US Real Estate Mortgage Investment Conduit (REMIC) rules.
The key documentation in a defeasance transaction are:
Defeasance account agreement
This agreement contains the instruction to the lender to hold the securities in a pledged account and governs the manner in which the account is to be operated and managed by the securities intermediary throughout the remaining life of the loan.
Defeasance pledge and security agreement
This agreement grants the lender a security interest in the securities (along with certain other collateral and the proceeds thereof) to secure the payment and performance of amounts payable under the loan documents. The trustee can then release the mortgage over the real property as the securities are substituted as collateral in place of the real property.
Defeasance assignment, assumption and release agreement
This agreement documents the assignment by the borrower and the assumption by the successor borrower of certain of the borrower's rights, duties and obligations under the loan and other defeasance documents.

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The borrower will want to ensure that the allocation of liability for any shortfall moves from the borrower to the successor borrower, and all representations (subject to certain exceptions such as fraud and misrepresentation) are transferred from the borrower to the successor borrower. The borrower also assigns its interest in the securities that have been pledged as collateral under the pledge agreement to the successor borrower.
Certificate of borrower
Provided by the borrower to confirm that all conditions to the defeasance process have been met.
Modification, waiver and consent agreement
Under this agreement the trustee will waive certain requirements under the loan documents for the defeasance of the loan that cannot be met (eg waiving the requirement for a rating agency confirmation)
Legal opinion
This is typically given in relation to the REMIC trust to confirm that the defeasance of the mortgage loan will not affect the status of the related REMIC. Additionally, a perfection and enforceability opinion will also be prepared to confirm a perfected security interest in the securities.
Rating agency confirmation
A confirmation that the defeasance process will not adversely affect the current rating of the securities may be required.
In 'new-note style' or 'New York style' defeasance transactions, the process is structured as an assignment rather than a release of the security, in order to avoid the payment of certain mortgage recording taxes. For these transactions, the following additional documentation will be required: o a defeasance note, which will be given by the borrower to the refinancing lender (the new lender)
Lender assignment, assumption and release agreement
Under this agreement the lender transfers the loan and the mortgage on the real property to the new lender in exchange for the defeasance note and the assumption of the new lender's obligations under the defeasance documents.
The property is released from the existing charge and the borrower released from all its obligations and liabilities in connection with the loan.
In certain cases, it is possible to defease the loan with securities costing less than outstanding principal balance of the loan (ie where the prevailing interest rate of the government securities is higher than the interest rate of the existing loan).
If negotiated at the time of loan origination, it is possible for the borrower to share in the residual value if there is accrued interest on the securities from the date of maturity until the date of payment of the relevant securities, or any residual value at the end of the loan term.
Defeasance offers an attractive option for borrowers, but difficulties may arise: o if the underlying government securities are subsequently downgraded from a required rating agency rating (if applicable), or o if the relevant securitised debt transaction is only partially defeased (eg the collateral is a combination of government securities and commercial real estate mortgages), the defeasance

Page 4 of a securitised loan can potentially negatively impact on the rating of the pool in which it is securitised
There are certain circumstances where defeasance may not be the most appropriate option, for example: o if the mortgage loan is cross collaterised with another mortgage loan and:
◦ the loan and/or the mortgage does not allow the severing of the cross collateralisation o
◦ upon defeasance of the mortgage loan, or where defeasance of both mortgage loans to sever the cross collateralisation is required, or where the criteria under the REMIC rules are not met
In these cases, yield maintenance, as an alternative to defeasance, may be a more attractive to borrowers.
As with the concept of defeasance, yield maintenance is prevalent in the US and is an alternative to the typical 'declining balance' formula for prepayment fees. As with defeasance, yield maintenance similarly seeks to ensure that any prepayment fee does not adversely impact the anticipated return to investors on the initial investment. However, yield maintenance differs from defeasance in that it does not involve the substitution of alternative securities for the underlying collateral, but is the actual prepayment of a loan using a predefined formula in the fixed rate loan agreement which is calculated using the current bond market yields to discount the remaining loan payments in the term.
Typically the yield maintenance payment consists of the unpaid principal balance of the loan and a prepayment penalty. The prepayment penalty is determined by calculating the replacement rate, which is the current yield on the relevant substitute sovereign securities that matures closest to the maturity date of the loan. The difference between the rate on the underlying loan and the yield rate of the relevant securities will be the replacement rate. Yield maintenance provisions usually incorporate a minimum payment of between
1% and 3% of the outstanding principal balance of the loan. This effectively puts a floor amount on the yield maintenance that the lender will receive.
Additional upfront costs involved are significantly less than with defeasance, as there are no additional parties to negotiate with, and no additional documents to enter into.
With no additional consent and notice requirements (other than those specified in the loan documents), the process is much simpler offering a quicker exit option to borrowers.
While upfront costs are reduced compared with defeasance, the overall costs can be greater as there is no opportunity to share in the residual value of the substituted securities.
The loan is prepaid, but no substitution of collateral or assignment of the debt occurs.
Due to the difficulty in modifying loans once originated, borrowers should ensure that favourable terms are negotiated at origination in relation to both defeasance and yield maintenance and included in the loan documentation (including, in relation to defeasance only, the ability to appoint a successor borrower).
Both defeasance and yield maintenance are attractive to investors and borrowers alike. For investors, the risk that the return on investment will be far lower than originally anticipated is greatly reduced. In relation to defeasance, the additional benefit to the lender is that the credit quality of the underlying collateral is actually

Page 5 enhanced, as the real estate is replaced with high grade sovereign securities. For borrowers, each option offers the flexibility of an early exit route for a defined cost.
In Europe, the concepts of defeasance and yield maintenance are not currently routinely seen in loan documentation and an advanced defeasance industry similar to that in existence in the US does not exist.
However, given the preponderance to prepayment in the European market in the past, and the fact that the
European commercial real estate market is seeing a number of US entrants familiar with the concept of defeasance and yield maintenance provisions emerge, there will likely be an increasing expectation that
European commercial real estate transactions will offer the same options to enable prepayment combined with a maintenance of the expected returns to investors in a refinancing or property sale situation. This has been seen to a limited extent with some US insurance companies introducing the concept of yield maintenance into European loan documentation in recent transactions and borrowers requesting the option to have flexibility to defease through substituting security.
The practice of defeasance and yield maintenance are well known in the US and a specialist industry has developed around these concepts. Related provisions in loan documentation are commonplace in US loans, and the chosen prepayment route identified and negotiated at loan origination. Defeasance and yield maintenance offer their own distinct benefits and disadvantages to borrowers, and the chosen prepayment mechanism will be largely dependent on a number of factors, including the commercial rationale for the transaction, and also market conditions at the time of origination and the predicted future yields of the substitute securities. With an increase in US entrants into the European market, there will be an appetite for yield maintenance and defeasance in loan documentation, which is already being reflected in the pricing structures currently being offered by US investors, and it is likely that the European markets will continue to witness a growth in such concepts.
The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.