As the commercial mortgage-backed securities ("CMBS") market in Canada has matured, it has experienced a growth in the use of defeasance as a strategy for borrowers whose mortgage loans have been securitized as part of a CMBS transaction. In an environment where property values continue to rise and Canadian interest rates are favourable, borrowers seek to capture the equity that is tied up in their real estate assets with refinance or sale transactions and the result has been a dramatic upswing in defeasance activity. McMillan Binch Mendelsohn LLP is the recognized market leader in the development and structuring of defeasance transactions in Canada. We work closely with servicers, sub-servicers, lenders, rating agencies and title insurance companies to ensure the successful completion of each defeasance transaction. No other Canadian law firm can match our level of expertise, service or commitment.
Our CMBS Services Group has completed more defeasance transactions than any other law firm in Canada. We are market pioneers for:
- The largest defeasance in Canada
- The first single asset pool defeasance transaction
- The first multi-loan, multi-pool defeasance
- Partial defeasance transactions
Complex, multi-step escrow closings
Our CMBS Services Group is also a proud member of the CMSA Taskforce, a group of recognized industry experts whose mandate is to develop the Canadian defeasance market and promote practices conducive to the efficient conduct of defeasance transactions. Our model documents have been adopted as the standard for a Canadian defeasance transaction.
What is Defeasance?
In its simplest form, defeasance is the process whereby a borrower replaces real property security with personal property security. The mortgage is discharged from the property and the borrower is free to sell or re-finance the property as it wishes. All obligations under the mortgage loan, other than those related to the use, operation or ownership of the property, remain in place, such as the obligation to continue to make payments under the mortgage loan. In exchange for a release of its mortgage, the mortgagee receives a pledge of a portfolio of bonds from the borrower. The bonds are generally high quality, triple A rated, sovereign risk (such as direct, non-callable, Government of Canada bonds) and are purchased such that the proceeds from the cash flow of the bonds replaces the expected income stream under the mortgage. Each future payment under the mortgage is notionally matched to a bond which comes due on or prior to a payment date such that the remaining payments due under the mortgage are replicated. Defeasance is a form of mathematically precise yield maintenance at the current bond rate.
The defeasance transaction is documented with two principal documents:
- Defeasance Pledge and Security Agreement - which governs the relationship between the borrower (pledgor), the conduit as mortgage lender (or more typically, the custodian acting for and on behalf of the investors of the conduit) and the master servicer (appointed as part of the securitization of the mortgage loan)
- Account Agreement - which governs the relationship between the pledgor, the mortgage lender and the master servicer Defeasance Pledge and Security Agreement
In accordance with the terms of the mortgage loan, the pledgor agrees to grant the mortgage lender a security interest in a basket of securities that comprise the defeasance collateral - normally Government of Canada bonds. The grant of the security interest and the delivery of the defeasance collateral to the mortgage lender to hold (among other requirements) triggers the right for a pledgor to have the lien of the mortgage released from the real property. The security interest created by the pledge is perfected by various means, including by registration of a financing statement pursuant to the Personal Property Security Act in the applicable jurisdiction and by means of passing all rights to control the defeasance collateral to the mortgage lender.
The Account Agreement has dual purposes. First, it sets out the instructions to the mortgage lender to hold the defeasance collateral in a pledged collateral account and to withdraw certain amounts from the income from the defeasance collateral each month and apply those amounts in satisfaction of the monthly payments due under the mortgage loan. Second, it further completes perfection by control under the Securities Transfer Act (Ontario) by placing all control over the defeasance collateral (the bonds) in the hands of the mortgage lender.
The Defeasance Collateral
Generally, the mortgage loan documents specify that direct, non-callable obligations of the Government of Canada are the only acceptable securities for use as defeasance collateral. In some circumstances, the various interested parties will permit the pledgor to use debt obligations which are of equivalent ratings, such as EDC and BDC bonds, each of which are debt obligations issued pursuant to the credit of the Government of Canada.
Ideally, the portfolio of bonds is structured so that each bond matures on or before a scheduled payment date under the mortgage loan, and the proceeds from the maturity of each bond are used to make the monthly payments due under the mortgage loan. In practice, Government of Canada bonds can be difficult to source, and in some cases, are not available for the required time period, leading to large cash balances being held in the pledged collateral account to cover many months of payments under the mortgage loan. Inefficiency in the bond portfolio raises the notional cost to the borrower, as cash sits unallocated and idle.
It is important to note that once a defeasance is complete, the mortgage loan remains in place, except for (i) the registration against the real property and (ii) the promises relating to the ownership, use and operation of the land. In Canada, defeasance does not release the borrower from its obligations under the mortgage loan. The obligations of the borrower, including the obligation to pay and all covenants not specifically related to the property (such as all events of default) continue to be operative until the final payment is made under the mortgage loan.
U.S. versus Canada
A U.S. defeasance practitioner would generally recognize and understand typical Canadian defeasance documentation, but there are a few notable exceptions. First and foremost among these is that the Canadian practice does not generally permit the use of a "successor borrower" structure, as is common in the U.S. In a defeasance transaction in the U.S., the loan obligation is typically transferred to a corporation controlled by the servicer (the "successor borrower") and then the defeasance is completed. Once the obligation to pay is assumed by the successor borrower, the original borrower is released from its obligations under the mortgage loan. From the borrower's perspective, the result of a U.S. defeasance operates like a discharge of the loan obligation. However, the U.S. style successor borrower transaction presents some difficulties under a Canadian CMBS conduit structure: a release of the original borrower and the novation of the mortgage loan may create potential tax liabilities for the CMBS investors.