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The Reasons Why so Many Borrowers in Structured Finance Transaction are Organized as Delaware Statutory Trusts
The Delaware statutory trust (“DST”) created under the Delaware Statutory Trust Act, 12 Del. C. §3801, et seq. (the “DST Act”), has emerged as the preferred special purpose vehicle (“SPV”) in structured finance transactions precisely because the DST Act was drafted specifically to accommodate the requirements of the structured finance market. As a result, the DST and the DST Act are so unique as to warrant a brief discussion of their history.
History of the Development of the Delaware Statutory Trust:
The history of the law of trusts is ancient: trusts were originally known in the ecclesiastical courts of England, and the development of the “modern” trust dates from the Statute of Uses, which was adopted in 1536. Consequently, trusts have been a part of the common law from the beginning of this country.
The use of trusts for the conduct of commercial enterprise originated in Massachusetts as a result of a quirk of Massachusetts law at the time which required a special act of the Legislature in order to obtain a corporate charter for the acquisition and development of real estate. The so-called “Massachusetts business trust” has been recognized in Delaware since 1947, when the Delaware Court of Chancery expressly recognized such an entity in Commonwealth Trust Co. v. Retirement Plan, 54 A.2d 739 (Del. Ch. 1947).
As a matter of law, such early business trusts differed principally from traditional trusts in that they were deemed to constitute separate legal entities for certain limited purposes, such as holding title to property and suing and being sued in the name of the trust (as opposed to in the name of the trustee), but otherwise they were treated in a substantially identical manner to traditional trusts.
Certain elements of traditional trust law, however, are particularly troublesome in a structured finance context. For example, under the common law, a trustee was generally held personally liable for the debts of a trust. In addition, the trustee was charged with broad fiduciary duties to the trust and to its beneficiaries, which duties imposed a strict standard of care on, and limited the availability of indemnity to, the trustee. Moreover, under the “control test”, a beneficiary who had the power to broadly direct a trustee in the administration of the trust could also be held liable for the debts of the trust, and under the theory that a creditor stands in the shoes of his debtor, the creditor of a beneficiary who had the power to terminate a trust also had the power to terminate the trust and use the trust assets to satisfy the debt of the beneficiary. This last point proved particularly troublesome in those jurisdictions (including New York and Delaware) where a sole settler/beneficiary was deemed to have the power to terminate a trust notwithstanding any language to the contrary in the governing trust agreement.
Between 1947 and 1988, the evolution of business trust law proceeded at a painfully slow pace. Some states enacted a patchwork of statutes which were designed to enhance the attractiveness of the use of trusts for business purposes, but most of such statutes were limited to administrative issues, or, in the case of Delaware, to the protection of the trustee (where statutory provisions were enacted, inter alia, to shield the trustee from liability where it acted in good faith reliance upon the express terms of a trust agreement and to limit the personal liability of a trustee for contracts entered into by the trustee solely in its fiduciary capacity).
Notwithstanding the inherent limitations of the common law business trust, many financiers developed a significant comfort level with using such trusts as finance vehicles, and a huge number of structured transactions were closed using common law business trusts, especially in the areas of ship, rolling stock and aircraft finance, during the 1970s and 1980s. Largely as a result of that built up comfort level, when the first collateralized mortgage obligation (CMO) transactions hit the market in the mid-1980s, the preferred vehicle was the Delaware common law trust.
As the CMO transactions became ever larger, however, many of the investors began to focus on the potential problems which might result from using the common law trust, and invariably such focus resulted in specific opinion requests of trust counsel For example, trust counsel began to be asked to opine that a specific common law trust constituted a separate legal entity, that no beneficial owner of the trust had any interest in specific trust property, and that no creditor of any beneficial owner could exercise any remedies with respect to the property of the trust. Unfortunately, these types of opinions were generally not able to be given under the common law of trusts without substantial qualifications.
The Delaware solution was the DST Act, which was initially adopted as the Delaware Business Trust Act in 1988 (the name was changed to the Delaware Statutory Trust Act on September 1, 2002). The DST Act was drafted by a committee of the Delaware State Bar Association comprised principally of lawyers who focused their practice in the corporate finance area. The goal of the drafting committee was to increase the utility of the trust in structured finance transactions by overruling those principles of the common law of trusts which were deemed disadvantageous and by including certain new provisions to statutorily authorize a high degree of freedom of contract between the trustor and the trustee in determining their respective liabilities and the manner in which the trust could be administered. In a rare case of having your cake and eating it, too, the DST Act expressly includes all pre-existing statutory and common law of the State of Delaware with respect to trusts, except to the extent that such law conflicts with the DST Act or the terms of the governing instrument of a trust formed under the DST Act.
Creation of a Delaware Statutory Trust:
A DST is easy to form and maintain; the only requirements are a governing instrument, such as a Trust Agreement or a Declaration of Trust, and the filing of a certificate of trust with the Delaware Secretary of State, which certificate need only set forth the name of the DST and the name and address of a trustee of the DST residing in Delaware (if an individual) or (if an entity) having its principal place of business in Delaware (the so-called “Delaware Trustee”). No other trustee or any beneficiary need be named in the certificate, and the governing instrument of the DST need not be filed with any public authority, preserving the confidentiality of such information. Subsequent to the filing of the certificate of trust, no further fees or filings (other than any amendments to the Certificate of Trust required to keep the information set forth therein accurate) are required for the life of the DST.
No Delaware Presence is Required:
A DST need not maintain a place of business or any of its records in Delaware.
Limited Liability of the Beneficial Owners:
Beneficial owners of a DST are entitled to the same liability protections that Delaware law provides to stockholders of a Delaware corporation (the common law “control test” is rejected), and trustees and other managers of the DST are not personally liable to third parties for acts, omissions, or obligations of the DST.
Contractual Flexibility of Delaware Statutory Trusts:
The express policy of the DST Act is to give maximum effect to the principle of freedom of contract and to the enforceability of governing instruments, permitting the draftsman of the DST’s governing instrument wide latitude in crafting provisions relating to the management and economic rights of owners, the duties and rights of trustees and managers, indemnification rights of all parties to the governing instrument, the authorization (or prohibition) of mergers and other mixed entity reorganizations, as well as other management and operational issues. Further, fiduciary duties owed by the trustees to the beneficial owners or the DST and related liabilities may be expanded, restricted or eliminated in the governing instrument; provided only that the governing instrument may not eliminate the implied contractual covenant of good faith and fair dealing.
Merger, Consolidation, Conversion, Division and Domestication for Delaware Statutory Trusts:
The DST Act also offers maximum flexibility in the ways to structure or restructure a DST. For example, under the DST Act, a DST may merge or consolidate with another DST or with an “other business entity” (including, but not limited to, corporations, limited liability companies, common law trusts, and partnerships), whether any such other business entity is formed or organized under the laws of Delaware or another jurisdiction. A DST may also convert into any “other business entity”, and the DST Act permits other business entities to convert into a DST. In addition, a DST may divide into two or more resulting DSTs. Finally, any non-United States entity may become domesticated in Delaware as a DST, and a DST may transfer to, domesticate or continue in any non-United States jurisdiction, and in connection therewith, may elect to continue its existence in Delaware as a DST.
Flexible Tax Treatment of Delaware Statutory Trusts:
A DST may be structured as a corporation, a partnership or a trust for federal and Delaware income tax purposes. In addition, a DST can qualify as a FASIT (financial asset securitization investment trust), a REMIC (real estate mortgage investment conduit), a REIT (real estate investment trust) or a RIC (registered investment company).
Federal and State Taxes:
A DST is not obligated to pay taxes to either the United States federal government or to the State of Delaware solely because the DST is formed under the laws of Delaware, however, in general, a DST may become subject to income taxes by the State of Delaware if it conducts business in the State of Delaware or it receives income form a source in the State of Delaware, and a DST may become subject to income taxes by the United States federal government if it conducts business in the United States or it receives income form a source in the United States.
Delaware Statutory Trusts As Borrowers Are Viewed Favorably By U.S. Rating Agencies:
A principal reason why Standard and Poors, Moodys and other U.S. rating agencies view DSTs as borrowers favorably is because they may be structured as bankruptcy remote entities. An entity is generally deemed to be bankruptcy remote if its assets may not be reached by creditors of the person (generally referred to as the Sponsor or Originator) from which it received a transfer of such assets. The following are examples of provisions of the DST Act which provide a DST with characteristics which favor bankruptcy remoteness:
Less Risk of Consolidation of Assets
A DST is a legal entity separate and distinct from its owners and managers. This separateness lessens the likelihood that a bankruptcy court will consolidate the assets and liabilities of the DST with those of its beneficiary.
More Protection for DST Assets
No creditor of a beneficial owner of the DST has any right to obtain possession of or exercise any legal or equitable remedies with respect to the property of the DST, and the governing instrument of a DST may provide that a beneficial owner has no interest in specific property of the DST.
Less Risk of Termination
A DST may not be terminated or revoked by a beneficial owner or other person except in accordance with the terms of its governing instrument. Further, a DST has perpetual existence and will not be terminated or dissolved by the dissolution, termination or bankruptcy of a beneficial owner (unless the terms of the governing instrument provide otherwise).
Minimizing the Risk of the DST’s Bankruptcy
A governing instrument may require the consent of an Independent Trustee for the DST to file voluntarily petition in bankruptcy or to consent to an involuntary bankruptcy petition. In addition, the DST Act does not require a DST to have a “business” purpose or to engage in “business”, the power and authority of a DST may be limited (e.g., by limiting such power and authority to the preservation of the assets of the DST) so as to render the DST ineligible to file as a debtor under the U.S. Bankruptcy Code.
Some Examples of Uses of Delaware Statutory Trusts:
- Asset Securitizations. A DST issues debt/equity securities backed by trust assets. Main advantage: protection of DST assets from creditors of originator of assets and creditors of beneficial owners of DST. Asset examples include:
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- municipal tax liens
- residential mortgages (CMOs and REMICs)
- real estate investment trusts (REITs)
- commercial mortgage loans
- financial asset securitization investment trusts (FASITs)
- collateralized bond obligations (CBOs)
- receivables (credit card, trade, installment sale, healthcare, etc.)
- automobile leases/loans
- corporate bonds and notes
- royalty interest trusts (oil/natural gas properties)
- Leveraged Leasing and Equipment/Collateral Trusts. A DST provides limited liability for equity investors, protects lessee and debt investors against risk of equity investor’s bankruptcy, and can significantly reduce the risk that the DST will become a debtor in bankruptcy.
- Like Kind Exchanges Under Section 1031 of the Internal Revenue Code. DSTs are frequently used to hold “replacement property” in Section 1031 like kind exchange transactions structured to comply with Revenue Ruling 2004-86.
- Structured/Synthetic Securities. A DST acquires and holds the security/asset to be repackaged, enters into a swap transaction to exchange cash flows with the swap counterparty, and issues to investor new debt and/or equity securities having the desired investment characteristics (based on cash flows received from swap counterparty).
- Synthetic Leases. A DST’s flexibility and bankruptcy-remote features, and the limited liability of DST beneficial owners, makes a DST a good choice to serve as Borrower/Owner/Lessor in Tax Retention Operating Lease (TROL) transactions.
- Registered Investment Companies. The DST’s flexibility is key advantage to registered investment companies:
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- no limit on number of beneficial owners/interests
- A DST can be authorized to redeem or issue additional beneficial interests without the consent of beneficial owners and without amending a public document or filing
- Inter-series liabilities can be limited to property of a particular series of beneficial interests
- No annual meetings are required.
DISCLAIMER
The foregoing information is for general informational purposes only and is NOT intended to constitute legal or business advice of any nature. Readers are advised to seek competent Delaware legal counsel before relying upon any of the information set forth above.