Legacy Finance Company is a non-depository financial institution headquartered in Boston, Massachusetts. Its primary business is to operate as a non-regulated finance company. It is capitalized through a combination of publicly registered stock and corporate bonds. Legacy has a business loan division and a commercial real estate loan division. Its business loan division originated $1 billion of various types of loans to middle market companies, secured by various types of assets including equipment leases, trade receivables, and inventory loans. These loans were originated during the period 2004-2007, before the financial meltdown occurred. During the same period of time, Legacy originated an additional $1 billion of loans secured by mortgages on commercial real estate located in various regions of the United States.
In 2008, Legacy attempted to securitize the $1 billion commercial real estate loan portfolio by transferring the real estate loans into a trust, causing the trust to elect real estate mortgage investment conduit (REMIC) status under the Internal Revenue Code, and taking back, in exchange for the loans, pass-through certificates aggregating $800 million in principal amount (including various senior and subordinated tranches) and a residual interest representing the right to receive residual cash flows after the regular interests are paid in full. However, just as the pass-through certificates in the REMIC were being marketed to investors, the collapse of the financial markets made it impossible to sell those securities, with a result that Legacy ended up holding all of the pass-through certificates and residual interests in the REMIC.
Since December of 2007, many of the loans in the REMIC have gone into default as a result of the deep recession, and others are facing their final maturities over the next 12 months. Due to the declining values of commercial real estate, the values of the underlying collateral have, on average, declined to 60 percent of their value in 2007. The loans in the REMIC were originally underwritten at 80 percent of the then fair market value of the real estate. Thus, the real estate underlying the $1 billion of loans was in 2007 worth $1,250,000,000, and the same real estate is today worth only $750 million. As a result, the aggregate mortgage balances of $1 billion are $250 million in excess of the aggregate underlying real estate values. This has rendered the $800 million of regular interests held by Legacy unmarketable.
Legacy did not securitize its $1 billion of business loans, but instead continued to hold those loans on its balance sheet and to service them directly. Also as a result of the economic recession, many of those loans are in default or are experiencing early signs of difficulty.
The chief financial officer of Legacy has consulted with you, as Legacy’s lawyer, about the following financial plan:
Since the existing REMIC securities are unmarketable, the company is considering taking one or more of the following actions to take advantage of the recent resurgence of the securitization market:
Option 1: Negotiate with each of the borrowers in the existing REMIC to restructure its loan into an A Note and a B Note, with the A Note and the B Note both being secured by the real estate under a common mortgage, but with the A Note receiving a priority claim on the property cash flows. The A Notes would be underwritten to assure that they would have loan-to-value and debt-service-coverage ratios sufficient to meet AAA rating standards. The A Notes would then be transferred by the REMIC to a newly created trust which would also elect REMIC status (“REMIC 2”). REMIC 2 would issue new commercial mortgage-backed securities secured by the A Notes, and these securities would be rated AAA and sold into the resurgent CMBS market, thus allowing REMIC 2 to pay cash to the first REMIC for the A Notes, and allowing the first REMIC to use those proceeds to repay the senior tranches under the first REMIC and thereby providing liquidity for Legacy.
Option 2: Under the second option, Legacy, as the holder of all of the pass-through certificates in the REMIC, would transfer its regular interests into a second newly formed trust, which would elect REMIC status (“REMIC 2”), and this trust would issue two classes of securities—one a senior security (Class A), having a priority claim on all of the cash flows on the underlying mortgages, and the second, a subordinated security (Class B), which would be subordinated to the Class A interests. By resecuritizing the mortgages in this way, Legacy would hope to obtain AAA ratings in the Class A securities, thus enabling Legacy to sell those securities and thereby provide liquidity for the company.
Option 3: Under the third option, Legacy, as the owner of the $1 billion portfolio of business loans, would securitize those loans by transferring them into a vehicle which will thereupon issue securities to institutional investors. The securities would be structured in such a way as to achieve a AAA rating on the class of securities having a senior priority claim to the cash flows and the collateral interests in the underlying loans, and Legacy would like to maximize the size of the AAA-rated class of securities, in order to achieve the greatest amount of liquidity for the company. Because of the declining quality of many of the business loans in this portfolio, Legacy is considering credit enhancing the securitization through either a senior-subordinated structure or by providing a recourse guarantee or put option with respect to a portion of the securities to protect the investors against loss.

Question 1

Please discuss, compare and contrast the U.S. income tax consequences of the transactions contemplated under Options 1 and 2.  In doing so, please consider and provide answers to the following questions:  

(a) What would be the income tax consequences of restructuring the loans in the existing REMIC into an A Note and a B Note?

(b) What would be the tax consequences of the original REMIC transferring the A Notes to REMIC 2?

(c) In the transaction contemplated under Option 2, would REMIC 2 qualify for REMIC status?

(d) As between Option 1 and Option 2, which would you recommend from a tax efficiency viewpoint?

(e) Can you recommend any alternative to Option 1 and 2 for addressing the unmarketability of the existing CMBS transaction and allowing Legacy to achieve the maximum liquidity?

Question 2

Assume that within the last 4 months there have been 4 successful CMBS securitizations where strong investor demand has resulted in the AAA-rated securities being oversubscribed and sold with very low coupons.  The investment bank which Legacy has selected to market the securities is eager to have the new securitization completed and into the market as quickly as possible.

(a) Analyze the merits and challenges posed by each of Options 1 and 2 with regard to being able to achieve the new securitization; and provide a recommendation to the investment bank as to which of the Options will permit the new securitization to be closed as quickly as possible.
(b) Assuming that the new securitization contemplated under either Option 1 or Option 2 will require analysis from rating agencies, so that the securities sold to investors will have a AAA rating, what factors would the rating agencies consider to arrive at their ratings of these new securities, and how would they go about determining these new ratings?
(c) Given that the US economy is just coming out of a major recession and given the recent meltdown in the securitization industry, what types of approaches might be considered in structuring the new securitization, to accommodate the needs and concerns of Legacy and potential investors for the securities?

Question 3

(a) In structuring a securitization of the business loans, in Option 3, how could true sale and substantive consolidation considerations complicate the desire to achieve the maximum AAA rating?

(b) Assume that a significant percentage of the business loans are separate loans made to special purpose subsidiaries of the same parent corporation. If the parent files for a Chapter 11 bankruptcy reorganization, what legal risks would Legacy as lender face?