Funds Talk: March 2018
Topics covered in this issue include:
- Regulators Seek Balance on Cryptocurrencies The SEC and CFTC chairmen testified they wish to encourage innovation in the burgeoning virtual currency market – but also warned that certain activities are "squarely in the crosshairs" of the regulators.
- SEC, FINRA Release 2018 Examination Priorities The financial market regulators’ 2018 priorities reveal a wide range of activities that could face examination, and asset managers must ensure they prepare accordingly.
- SEC Publishes Cybersecurity Guidance As cybersecurity events become more frequent and the risks increase in magnitude, the SEC issued guidance for public companies regarding how public companies should react – whether or not they’ve been affected by a breach.
- Financing Considerations for Ground or Net Leased Real Estate Investments Ground leases serve an important function in real estate ownership and, while owners’ motivations for entering into a ground lease may vary, all participants should be aware of a key financing issue that continually arises in these transactions.
U.S. Senate Hearing on Cryptocurrencies
On Feb. 6, Jay Clayton and Christopher Giancarlo, the chairmen of the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), respectively, jointly testified before the Senate Banking Committee to discuss the regulatory oversight of cryptocurrencies.1 Their testimony highlighted that both the SEC and the CFTC are seeking to strike the right balance in this area by trying to protect the public against manipulation and fraud while also encouraging innovation. They discussed subjects ranging from the authority of both the SEC and CFTC to oversee the cryptocurrency markets to the possibility of cryptocurrency exchange-traded funds (ETFs) being approved by the SEC.
Regulatory Oversight of the Cryptocurrency Market
Currently the SEC and the CFTC are authorized to regulate only the aspects of the cryptocurrency markets that fall under their jurisdiction. When asked by committee members about the passage of legislation that would expand the SEC’s and CFTC’s regulatory reach to explicitly include cryptocurrencies and whether additional funding would be necessary for them to oversee the cryptocurrency market, both Clayton and Giancarlo said that they would consider this further and provide their complete thoughts to the committee at a later date. Clayton stressed that the current hiring freeze limits his agency in its capacity to oversee the markets. Giancarlo noted that giving the CFTC direct authority over spot market trading (which would be needed to oversee such activity in cryptocurrencies) would constitute a “dramatic expansion” of its mission.
ICO Tokens Generally Viewed as Securities
Consistent with previous statements, Clayton expressed the view that initial coin offering (ICO) tokens should comply with securities laws (when applicable) given that “I believe every ICO I’ve seen is a security …” and that the problem is that none of them have registered with the SEC as securities offerings. Clayton also warned professionals providing advice to ICOs, “Those who engage in semantic gymnastics or elaborate re-structuring exercises in an effort to avoid having a coin be a security are squarely in the crosshairs of our enforcement provision.”
Cryptocurrency Futures Market
Giancarlo discussed the recent listing of bitcoin futures by the CME and CBOE exchanges and the self-certification approach adopted by the CFTC in connection with these products. Giancarlo indicated that this self-certification process is being undertaken by the exchanges voluntarily, with such exchanges also implementing enhanced risk management and monitoring for these products. Giancarlo also explained that the existence of a futures market in bitcoin is advantageous from a regulatory standpoint because the CFTC gains visibility into underlying markets and spot markets that it would not otherwise have. Giancarlo further indicated that due to the existence of bitcoin futures and the related trading data, the CFTC has an enhanced ability to identify fraud and manipulation in the bitcoin futures markets.
When Sen. Mark Warner (who expressed a good level of familiarity with the area) called for more coordination between the CFTC and the SEC and inquired why bitcoin futures were allowed while the SEC was still blocking ETFs, Clayton mentioned that certain issues regarding the custody of cryptocurrency assets, their volatility and their price discovery would have to be resolved before the SEC could approve cryptocurrency ETFs.
Overall, both the SEC and the CFTC struck a cautiously optimistic tone with respect to distributed ledger technology by indicating that the technology holds a lot of promise, including with respect to its role in the future of payment systems and financial markets. In this regard, Giancarlo mentioned in his opening statement the interest of young people in bitcoin (including his own children) and said that regulators should “respect their enthusiasm about virtual currencies with a thoughtful and balanced response, not a dismissive one.” Nevertheless, both regulators stressed that regulatory oversight is necessary and the nature of such regulation needs further thought.
1 Giancarlo’s written testimony can be found here: http://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo37
Clayton’s written testimony can be found here: https://www.sec.gov/news/testimony/testimony-virtual-currencies-oversight-role-us-securities-and-exchange-commission
The webcast of the hearing can be seen here: https://www.banking.senate.gov/public/index.cfm/hearings?ID=D8EC44B1-F141-4778-A042-584E0F3B9D39
SEC, FINRA Target ICOs, Cybersecurity, Secondary Market Trading in 2018 Examination Priorities
Both the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) recently released their respective 2018 examination priorities, providing a glimpse into their plans for the year to come.
Many of the areas they highlighted will directly affect the alternative investment sector, and private fund advisers and securities firms should pay particular attention to their activities in such areas. Investment managers should review and/or update their policies and procedures in these areas and in general ensure their compliance with the SEC’s and FINRA’s requirements.
The SEC’s Office of Compliance Inspections and Examinations’ (OCIE) 2018 examination priorities focus on practices, products and services it believes may present a “potentially heightened risk to investors and/or the integrity of the U.S. capital markets.” In addition to activities related to critical market infrastructure and the protection of retail investors, OCIE indicated that developments in the cryptocurrency and the initial coin offering (ICO) markets would be “of particular interest this year.” Where these products are securities, the SEC stated it would monitor them for regulatory compliance, with a focus on whether financial professionals maintain adequate controls and safeguards to protect these assets from theft or misappropriation, and whether financial professionals are “providing investors with disclosure about the risks associated with these investments, including the risk of investment losses, liquidity risks, price volatility, and potential fraud.” This continued regulatory focus on ICOs follows the SEC’s increased scrutiny of cryptocurrencies as the offerings surged in popularity during 2017.
The SEC’s examination priorities outlined five general areas of interest, many of which could affect private fund advisers:
- Compliance and risks in critical market infrastructure
- Matters of importance to retail investors, including seniors and those saving for retirement
- FINRA and the Municipal Securities Rulemaking Board (MSRB)
- Anti-money laundering (AML) programs
With regard to oversight of critical market infrastructure, OCIE said it will “continue to examine entities that provide services critical to the proper functioning of capital markets.” This will include examinations of such firms as clearing agencies, national securities exchanges and transfer agents, with a particular focus on certain aspects of their operations and compliance with recently effective rules.
With respect to the priority of protecting retail investors, the SEC will focus on whether the retail investor’s investment professional makes the proper disclosure and calculation of fees, expenses and other charges investors pay. In addition, OCIE will be looking for adequate disclosure of any conflicts of interest that may push financial professionals toward recommending certain products or services, “including any higher cost or riskier products.” Further, examiners will focus on firms with practices or business models that could involve inadequately disclosed fees or other expenses, including “private fund advisers that manage funds with a high concentration of investors investing for the benefit of retail clients,” such as retirement accounts. Finally, the SEC will continue to make risk-based assessments and select for examination those investment advisers that have elevated risk profiles, which may include those that have never been examined, those that have not been examined in some time, and those that provide investment advice through automated or digital platforms, including “robo-advisers.”
The SEC’s priorities for 2018 also include oversight of FINRA, noting that the registered national securities association acts as a primary regulator of the vast majority of SEC-registered broker-dealers. As such, the SEC said it will focus on FINRA’s operations and regulatory programs, as well as “the quality of FINRA’s examinations of broker-dealers and municipal advisors that are also registered as broker-dealers.” With regard to the Municipal Securities Rulemaking Board, which regulates broker-dealers that buy, sell and underwrite municipal securities, while also regulating municipal advisers, the SEC will seek to “evaluate the effectiveness of select operational and internal policies, procedures, and controls.”
Cybersecurity has been an ongoing area of interest for the SEC in recent years, and that focus will continue in 2018. In response to the dramatic rise in the “scope and severity” of cyber risks, its 2018 examinations will continue to focus on, among other things, governance and risk assessment, access rights and controls, data loss prevention, vendor management, training, and incident response. Fund managers should ensure their cybersecurity policies and procedures are in compliance and avoid common shortcomings.
Finally, with respect to AML programs, the SEC will continue to evaluate whether covered firms – such as broker-dealers and investment companies – are fulfilling their AML obligations. This will include, among other activities, compliance with the customer due diligence requirement, whether covered entities are taking reasonable steps to understand the nature and purpose of customer relationships, and taking steps to properly address risks. In addition, the SEC will monitor whether entities are filing timely, complete and accurate Suspicious Activity Reports and whether entities are conducting robust and timely independent tests of their AML programs.
As for FINRA, many of its 2018 regulatory and examination priorities mirror many of the SEC’s examination areas, such as a focus on ICOs, cybersecurity and AML activities. FINRA lists several areas of ongoing inspection, such as fraudulent activities – including insider trading, pump-and-dump and Ponzi-type schemes, and micro-cap fraud schemes targeting seniors – and high-risk firms and individual brokers, which FINRA will continue to inspect for compliance in their remote supervision arrangements; supervision of point-of-sale activities, including individual broker accountability when using joint rep codes; and branch inspection programs.
FINRA also announced plans to launch report cards designed to assist firms with their compliance efforts in three areas:
- The Auto Execution Manipulation Report Card will focus on instances in which a market participant uses non-bona fide orders to move the national best bid or offer (NBBO).
- The Alternative Trading System Cross-Manipulation Report Card will examine the potential manipulation of the NBBO, which results in the modification of a security’s prevailing midpoint price on an alternative trading system crossing venue.
- The Fixed Income Mark-up Report Card will provide information to firms – including median and mean percentage markups for each firm – and the industry, which firms will be able to display based on certain criteria such as investment rating, product (e.g., corporate or agency) and length of time to maturity.
FINRA indicated it may add more products in the future and will review “whether and how firms make use of” the report cards.
Finally, FINRA highlighted several significant new rules currently scheduled to take effect in 2018, adding that it may discuss with certain firms the actions they are taking to meet their obligations under the rules, which include:
- FINRA Rule 2165: Financial Exploitation of Specified Adults (effective Feb. 5)
- Amendments to FINRA Rule 4512: Customer Account Information (effective Feb. 5)
- FinCEN’s Customer Due Diligence Rule: Firms have until May 11 to comply
- Amendments to FINRA Rule 2232: Customer Confirmations (effective May 14)
- Amendments to FINRA Rule 4210: Margin Requirements for Covered Agency Transactions (effective June 25)
- FINRA Rules 1210 through 1240: Consolidated FINRA Registration Rules (effective Oct. 1)
These areas will make up the core of the SEC’s and FINRA’s regulatory activities for the months ahead. However, the regulators warn they are not exhaustive lists and that they will continue to monitor for any new areas of concern that may appear in the industry and respond to any further developments using a risk-based approach. As a result, private fund advisers should remain vigilant for any additional statements and guidance from regulators in the months ahead.
SEC Guidance Focuses on Cybersecurity Procedures and Disclosure Issues
On Feb. 21, the Securities and Exchange Commission (SEC) released interpretive guidance on public companies’ disclosure practices regarding cybersecurity breaches and risks to the public.
The guidance reinforces and expands upon the SEC Division of Corporation Finance’s October 2011 guidance, which stated that although no disclosure requirement explicitly referring to cybersecurity risks and cyber incidents existed at that time, companies nonetheless may be obligated to disclose such risks and incidents. The SEC’s latest guidance addresses in greater detail two additional topics: the importance of cybersecurity policies and procedures and the application of insider trading prohibitions in the cybersecurity context.
Generally, the guidance states that – given the “frequency, magnitude and cost of cybersecurity incidents” – companies should inform investors about material cybersecurity risks, even if the company has not yet been the victim or target of a cyberattack. It states that firms should have policies and procedures in place to publicly disclose breaches in a timely fashion and to prevent corporate insiders from exploiting their knowledge of a cybersecurity incident by trading on material non-public information before the breach is publicly disclosed. It also recommends that the most effective cybersecurity disclosure controls and procedures result when a company’s directors, officers and others are informed about the risks and incidents that the company has faced or is likely to face.
The first section of the guidance outlines the existing rules requiring disclosure of cybersecurity-related issues and provides guidance on the timing, nature and amount of disclosure expected. It reminds issuers that they are required to establish “appropriate and effective disclosure controls and procedures that enable them to make accurate and timely disclosures of material events, including those related to cybersecurity” to assist in meeting their disclosure obligations under federal securities laws. It recommends firms consider the materiality of cybersecurity risks and incidents to investors when preparing disclosure in registration statements, current reports and periodic reports, while also considering the adequacy of their cybersecurity-related disclosure to avoid omitting any information that could result in a misleading disclosure.
Despite the need for adequate disclosure, the guidance clarified that a company need not make disclosures so detailed that they could compromise cybersecurity efforts and that the SEC does “not expect companies to publicly disclose specific, technical information about their cybersecurity systems, the related networks and devices, or potential system vulnerabilities in such detail” that it would make them more susceptible to a cybersecurity incident.
In relation to the disclosure of a company’s risk factors, the guidance provides several factors to be considered in evaluating the level of risk, such as the occurrence of prior cybersecurity incidents, the probability and potential magnitude of cybersecurity incidents, the adequacy of preventive actions taken to reduce cybersecurity risks, and the associated cost, as well as the risk of reputational harm, litigation or regulatory investigation as a result of a cybersecurity incident. In addition, the SEC expects a company’s financial statements will include information regarding the range and magnitude of the financial impact of a cybersecurity event “on a timely basis as the information becomes available.”
Policies and Procedures
The guidance then expands on existing SEC statements to emphasize the importance of creating and maintaining comprehensive risk management policies and procedures specifically related to cybersecurity risks and incidents. It encourages firms to assess disclosure controls and procedures to ensure that relevant cybersecurity information “is processed and reported to the appropriate personnel, including up the corporate ladder, to enable senior management to make disclosure decisions and certifications.” It also calls for the creation of policies and procedures that prohibit directors, officers and others from making trades based on non-public material information.
Further, the guidance states that disclosure controls and procedures should “ensure timely collection and evaluation of information potentially subject to required disclosure, or relevant to an assessment of the need to disclose developments and risks that pertain to the company’s businesses.” The guidance encourages companies, when designing and evaluating disclosure controls and procedures, to consider whether they will appropriately record, process, summarize and report the cybersecurity-related information they are required to disclose in filings. Disclosure controls and procedures should also enable companies to “identify cybersecurity risks and incidents, assess and analyze their impact on a company’s business, evaluate the significance associated with such risks and incidents, provide for open communications between technical experts and disclosure advisors, and make timely disclosures regarding such risks and incidents.”
Significantly, the guidelines include an emphasis on considerations related to insider trading. In the interests of safeguarding against officials trading on non-public information before a cyber incident is disclosed, the guidance suggests companies consider adding the specific context of a cyber event to any preventive measures they may have already adopted to address the appearance of improper trading. This inclusion comes after several high-profile hacking incidents – including at the SEC itself – implicating trading on non-public information. The guidance underscores that non-public information, regarding a company’s cybersecurity risks or breaches may constitute material, non-public information and corporate insiders would violate anti-fraud provisions should they use any such knowledge to trade the company’s securities.
As a result, the SEC encourages companies to review their codes of ethics and insider trading policies through a cybersecurity lens in order to prevent such activity. In addition, it suggests that firms investigating cyber incidents should consider “whether and when it may be appropriate to implement restrictions on insider trading in their securities.” The guidance states that such a measure could protect against corporate insiders engaging in such activities and help affected companies “avoid the appearance of improper trading” in the wake of a cybersecurity breach. The guidance also emphasizes that in disclosing cybersecurity events, issuers need to be mindful of the prohibitions against selective disclosure embodied in Reg FD and ensure that when a disclosure is made to an enumerated Reg FD person (such as a broker, investment adviser or holder likely to trade in company shares), disclosure is simultaneously made to the public.
The guidelines remain “guidance,” rather than any formal rule change. In a statement released with these guidelines, Chairman Jay Clayton noted that the guidelines reflect “the Commission’s views on this matter to promote clearer and more robust disclosure,” so that investors receive more complete information. Clayton reminded companies that investors may find fault with a company’s actions even when the SEC does not. “In particular, I urge public companies to examine their controls and procedures, with not only their securities law disclosure obligations in mind, but also reputational considerations around sales of securities by executives,” he said, a reminder that other considerations exist beyond regulatory requirements when it comes to cybersecurity. Clayton also emphasized that the SEC would continue to evaluate and monitor developments concerning cyber disclosure and consider whether additional guidance or rules may be needed.
Certain Financing Considerations When Investing in Ground Leased or Net Leased Real Estate
This note briefly looks at an issue that continually arises in connection with the financing of ground leases (as well as long-term triple net leases generally), of which any real estate fund looking to invest in such instruments or in property subject to such instruments should be mindful. Unfortunately, as Moody’s guidance on the subject1 points out, while “neither new nor cutting edge,” this issue “arises again and again” — namely, the priority of the landlord/fee lender’s position vis-a-vis the tenant’s leasehold financing. Most real estate lawyers, whether operating in the “dirt” real estate or real estate finance field, know this issue to be pervasive. But somehow, the solution often seems not quite “within the grasp” when fashioning definitive lease documentation.
First, a brief primer. Ground leases, among other forms of so-called triple net leases, serve an important function in real estate ownership. Often, real estate owners, seeking to monetize unimproved or otherwise developable land but desiring to retain a residual ownership interest, will enter into a long-term “ground lease” under which the tenant typically will lease land and construct improvements upon or otherwise develop the land and then itself operate, sublease or otherwise monetize the land (as so improved or otherwise developed) for the tenant’s own benefit; in return, the tenant may pay the landlord upfront consideration and/or periodic rental payments for the duration of the lease term. At the end of the lease term, all interest in the land and improvements reverts to the landlord.
The possible reasons that an owner may ground lease property rather than sell the same outright are numerous and varied, and include tax considerations, a familial or institutional desire to retain underlying control of the land, or simply a desire to collect a stable coupon and generate long-term value. In New York City, in particular, ground leases are an enduring part of the real estate landscape.2 Ground leases usually are of lengthy duration, often with terms of up to 99 years or even longer, and accordingly are complex, nuanced creatures.
Among other issues that the typical ground lease must address is the financeability of the leasehold position. In particular, because ground leases often involve significant upfront investment by the tenant in connection with construction and/or development of the leased property, the extent to which the tenant’s possessory interest in the property for the duration of the term of the lease may be financed and collateralized is of significant concern, and a ground lease’s failure to provide the protections that lenders ordinarily require in order for a ground lease to be financeable will sound its death knell. To be sure, numerous tomes have been written on the ways to make a ground lease financeable; the essentials include ensuring the lease expressly allows the tenant’s leasehold interest to be financed and collateralized as a separate interest; providing the leasehold lender with sufficient notice and cure rights in the case of tenant default under the lease (after all, should the landlord simply terminate the lease following the tenant’s default, the lender’s leasehold collateral will immediately disappear — thus, leasehold lenders ordinarily demand extensive notice and cure periods); granting the lender or its designee the right to enter into a new, replacement lease with the landlord if the lease is terminated or is rejected in bankruptcy; addressing priorities with respect to application of insurance proceeds; restoration following casualty; and various other items.
Financing Priority Puzzle
In addition, the binary nature of a ground lease — insofar as it comprises two distinct ownership interests in a single piece of real estate: (i) the tenant’s leasehold interest, together with the income the tenant may derive from the leased property, and (ii) the landlord’s post-lease-term residual fee interest, together with the expected stream of rent payments payable during the lease term by the tenant to the landlord, each of which interests may be separately financed by the tenant and the landlord, respectively — presents yet an additional puzzle: to wit, how to address the question of overall priority as between the tenant’s leasehold lender’s financing and the landlord’s fee lender’s financing, which are each secured by the same piece of real estate (albeit with different interests therein).
The landlord, while presumably committed to allowing the tenant to obtain financing for the construction of tenant’s improvements (and subsequent refinancings thereof),3 will wish to ensure that the tenant and its lender remain subject to the lease and obtain no greater rights beyond the four corners of the lease that can otherwise impact the landlord or compromise its right (or that of a fee mortgagee should it become the landlord following exercise of remedies) to the rental stream under the lease and the residual fee interest. To that end, landlords may seek to expressly provide in the ground lease that any leasehold financing is subordinate to the lease and to any fee mortgage thereof.
For a leasehold lender, such a provision is anathema. It would enable the landlord’s fee mortgagee, if it were to foreclose upon landlord’s fee interest following the landlord’s default under the fee mortgage loan, to contemporaneously foreclose on and wipe out the tenant’s leasehold interest and any corresponding leasehold financing. Assuredly, this is an unacceptable result for the leasehold lender. And, in fact, from the perspective of the leasehold lender, for so long as the tenant (and by extension the leasehold lender) is not in default under the lease, the leasehold lender’s interest must at all times remain paramount to the interest of the fee mortgagee. Accordingly, for the leasehold lender, optimally, the ground lease will provide that the fee mortgagee’s interest remains subject in all cases to the ground lease.
Truth be told, the landlord and its fee lender ought to accept the leasehold lender’s position and allow the fee lender to be subject to the ground lease, provided it was made absolutely clear that such subjection stops at the edge of the ground lease, and that under no circumstances does such subjection provide the leasehold lender with the ability to impair the right of the landlord or its lender (as applicable) to terminate the lease in the event of the tenant’s default thereunder (following sufficient notice and cure rights afforded to the leasehold lender) or otherwise affect their rights, respectively, in the residual fee interest. Indeed, the correct result, it would seem, is for both the leasehold lender and the fee lender to obtain no advantage over the other, and for each, should it foreclose, to land in the same position that its respective mortgagor would be under the lease absent having entered into any such financings.
Unfortunately, however, many existing ground leases, both in New York City and elsewhere,4 do not treat priority issues in this fashion. Rather, many ground leases, particularly the older ones, subordinate the lease to the fee lender’s financing and attempt to solve the leasehold lender’s problem via an SNDA (i.e., a separately made “subordination, non-disturbance and attornment agreement” among landlord, tenant and fee lender), which ordinarily provides, in essence, that, notwithstanding that the lease is subordinated to the fee lender’s mortgage, for so long as the tenant (and by extension the leasehold lender if acting on behalf of the tenant) is not in default under the ground lease, the fee lender will recognize the tenant and its leasehold interest pursuant to the lease following a foreclosure of the landlord’s fee interest.
The problem with the SNDA solution, however, is that an SNDA is an executory contract, and may be rejected under Section 365 of the Bankruptcy Code by the fee lender in the case of its own bankruptcy. Should this occur, the fee lender could then free itself of the obligation to recognize the tenant under the SNDA, but still foreclose under the fee mortgage and wipe out the leasehold lender’s position. While seemingly a far-fetched scenario, particularly if the fee lender is a significant institutional lender (this would require a sequence of events such that, among other things, the landlord will have defaulted under its fee loan and the fee lender is separately in bankruptcy; though in truth such a scenario may not be difficult to envision given events following the Great Recession of 2008 and its aftermath), lenders, particularly CMBS lenders, view this as a significant flaw. Moody’s, in published guidance for CMBS issuances,5 takes the position that an “SNDA does not sufficiently mitigate the risks inherent when fee financing is superior to the lease and leasehold mortgage” because the SNDA may be deemed an executory contract that could be rejected in the fee lender’s bankruptcy or may be declared unenforceable upon the fee lender’s insolvency and takeover by the FDIC under 12 U.S.C. § 1823(e).6 While this issue can be addressed when entering into a new lease by subjecting any current or future fee mortgage to the lease in the manner noted above, using the SNDA mechanism with a refinanced leasehold secured by an existing ground lease may raise concerns with lenders, particularly in the case of CMBS originations.
A possible way out of the problem is to obtain the fee lender’s agreement in an SNDA that if it fails to abide by the terms of its agreement to recognize the tenant or otherwise seeks to terminate the lease in violation of its agreement not to join the tenant in a fee foreclosure, then any subordination to such lender’s mortgage is automatically terminated and the lease is deemed superior to the lien of the mortgage. Of course, such agreement itself may be deemed executory and possibly rejected, so this will not fully resolve the issue.
Triple Net Leases
To be clear, the issue described above not only affects ground leases, but also arises in just about any case of a triple net lease. A ground lease is really just a specialized form of triple-net lease, which is a form of lease agreement where the tenant is responsible to maintain and operate the property and pay all expenses thereof, including real estate taxes, utilities, insurance and maintenance, in addition to paying the rent, leaving the landlord in an essentially passive position such that it basically just collects the rent. Whereas ground leases are often used as a tool to develop or improve raw or underdeveloped land, triple net leases, which abound as investment instruments, are extensively used as a means of leasing just about any property class. Tenants under triple net leases are often investment-grade, and may include players from a variety of sectors including retail, pharmacy, banks, restaurants, warehouses and just about any other asset class, including operators of more complex, management-intensive uses involving hotels, casino/gaming operations, health care facilities and other types of property, while the landlords (particularly when dealing with investment-grade tenants) can be REITs, insurance companies, pension funds and myriad other types of investors.
As with the ground lease, in a triple net lease the tenant may seek to finance its position with a leasehold mortgage financing while the landlord may also seek to secure fee mortgage financing, resulting in the similar question posed under the ground lease — that is, how to address priority as between the two separate financings that affect a single piece of real estate? It would seem that the appropriate approach here too would be for the landlord and its fee lender to allow for the fee mortgage to be subject to the ground lease, with appropriate clarifications, similar to those described above, to avoid impairing the landlord’s or fee lender’s position as provided under the lease. It should be noted that such an approach is generally more easily implemented in leases in which the landlord’s interest is truly passive, whereas the less passive the landlord’s interest, the harder it is to reach this result. Further, in triple net leases that involve complex opco-propco structures and/or where the underlying property operated by the tenant that supports the landlord’s rental stream is very management-intensive, the resolution of this question can be far more complex, but such circumstances are outside the scope of this note.
The bottom line: When crafting a ground lease or any other form of triple net lease (and when investing in any such instrument), special attention should be given to the tensions that arise as a result of both tenant and landlord potentially seeking to finance their respective positions, and, in particular, the relative priorities of the leasehold financing and the fee financing. In ground leases involving construction or other development projects in particular, given there is usually significant upfront tenant investment, the tenant’s leasehold financing may need particular deference when crafting applicable priority and subordination language. The refinancing of existing leases that run afoul of the rating agency guidance on this topic and do not adequately provide for the fee mortgage to be subordinated to the lease may need special attention to assuage lender concerns over financeability.
1 Moody’s Investor Service, The Top Two Ground Lease Financing Flaws: Deficient “New Lease” Clauses and Superior Fee Mortgages, Jan. 6, 2016.
2 The desire to retain residual ownership is often found in the case of religious, educational and governmental institutions. In fact, in New York City, for example, some of the largest landowners (both currently and historically) include such parties. (See Aleksey Bilogur, Who Are the Biggest Landowners in New York City?, May 27, 2016, http://www.residentmar.io/2016/05/27/biggest-landowners-nyc.html.) Ground leases made by such landowners, as well as various families with interests in large swaths of New York City real estate, among others, are an ever-present feature of New York City real estate.
3 Indeed, tenant’s financing, which enables the tenant to construct improvements or otherwise develop the leased property and thereby to subsequently monetize the fully constructed/developed asset and pay the required rental under the lease to the landlord, is indirectly the essential means by which the landlord ultimately derives value from the property; consequently, the landlord is incented to ensure the tenant’s ability to secure such financing and subsequently refinance the same for the duration of the lease term.
4 Given the lengthy duration of many ground leases, many older New York City ground leases, covering significant properties and first implemented in the 1980s and prior, remain in effect. Such leases predate many of the sophisticated lending practices currently in effect, that have been promulgated in connection with CMBS issuances and other lending practices of more recent vintage.
5 Moody’s Investor Service, The Top Two Ground Lease Financing Flaws: Deficient “New Lease” Clauses and Superior Fee Mortgages, Jan. 6, 2016.
6 See, e.g., Kimzey Wash, LLC v. LG Auto Laundry, LP, 418 S.W.3d 291, Tex. Court of Appeals, 5th Dist. 2013, cited in the Moody’s article cited above, which uses 12 U.S.C. § 1823(e) and the D’Oench, Duhme doctrine to declare unenforceable an SNDA made by a fee lender subsequently taken over by the FDIC. The FDIC transferred such lender’s assets to a different bank, which consummated a foreclosure of the applicable mortgage and effectively wiped out the leasehold interest purportedly protected by the SNDA.