VOL 36, NO 2 MAR/APR 2022
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Planning for the Risk of Trust Litigation with Trust Situs or Governing Law Selection
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Planning for the Risk of Trust Litigation with Trust Situs or Governing Law Selection By: Timothy M. Ferges
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CFTC and SEC Perspectives on Cryptocurrency and Digital Assets - Volume I: A Jurisdictional Overview By: Stephen M. Humenik, Cheryl L. Isaac, Keri E. Riemer and Christine Mikhael
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Green Book Proposals Related to Estate and Gift Tax By: Samuel Olchyk and Allison R. Church
Articles Editor for Real Property Cheryl Kelly (RP) Articles Editor for Trust and Estate Ray Prather (TE)
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Estate Administration: The Digital Assets Dilemma By: Laura Walliss
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Spotlight: Wealth Structuring and Regulation in Canada By: Margaret R. O’Sullivan and Marly J. Peikes
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FinCEN Commences Rulemaking Process to Implement AML Reporting Requirements for Real Estate Sector By: Betty Santangelo, Melissa Goldstein, Julian Wise and Hadas Jacobi
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Directors and Officers Liability Insurance: An Essential Coverage for the Real Estate and Construction Industry By: Craig M. Hirsch
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Fracas in the French Quarter: Fifth Circuit Weighs in on the Ongoing Controversy Over the Intersection of Bankruptcy Code Sections 363(f) and 365(h) By: David Farrell
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Rethinking Force Majeure Clauses in Commercial Leases in Response to COVID-19 By: Daniel Q. Orvin
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Editor Robert Steele (TE)
Assistant Real Property Editors John Trott (RP) Katie Williams (RP) Sarah Cline (RP) Assistant Trust and Estate Editors Keri Brown (TE) Brandon Ross (TE) Anne Kelley Russell (TE) Technology/Practice Editor for Trust and Estate Martin Shenkman (TE)
Can We Save Time by Using a Negotiated Document from Another Deal? By: Joshua Stein
The materials contained herein represent the opinions of the authors and editors and should not be construed to be those of either the American Bar Association or the Section of Real Property, Trust and Estate Law unless adopted pursuant to the bylaws of the Association. Nothing contained herein is to be considered the rendering of legal or ethical advice for specific cases, and readers are responsible for obtaining such advice from their own legal counsel. These materials and any forms and agreements herein are intended for educational and informational purposes only. © 2022 American Bar Association. All rights reserved.
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Planning for the Risk of Trust Litigation with Trust Situs or Governing Law Selection By: Timothy M. Ferges When including trust situs and governing law provisions, estate planners often focus on tax and asset protection issues. This article describes how these provisions affect trust litigation in ways that are rarely considered at the planning stage. When litigation arises relating to administration of a trust, the procedural law of the forum state can have a profound effect on the proceeding. Likewise, the substantive law that would govern a trust’s administration may vary significantly from state to state. As our society becomes more mobile, we are no longer so committed to one particular jurisdiction when creating a trust. But in determining where a trust will be administered or in the selection of a trust’s situs or governing law, estate planners tend to limit their focus on issues other than the potential for litigation -- such as the creditor protection available in a particular jurisdiction, the taxes that SPRING 2022
a particular state would impose on the trust’s income, or other matters. In some cases, it could serve the grantor well to also consider the possibility of litigation and how a dispute might play out before the courts of one jurisdiction versus another. This can be particularly true where a grantor has specific concerns regarding a litigious beneficiary or family member. As a general matter, the administration of a trust “is supervised by the courts of that state only in which the administration of the trust is located.” Restatement (First) of Conflict of Laws § 299. In the case of a testamentary trust, that is presumed to be the state of the testator’s domicile upon her death. Id at § 298, comment a; N.J.S.A. 3B:31-8(a). In re Johnston, 127 NJ Eq. 576 (Prerog. 1940), affirmed 129 N.J.Eq. 104 (E. & A. 1941). A grantor of an inter vivos trust may specifically designate in the trust instrument the principal place of the trust’s administration. Such designation will be respected by the court of designated jurisdiction so long as: “(1) a trustee maintains a place of business located in or a trustee is a resident of the designated jurisdiction; or (2) all or part of the administration occurs in the designated jurisdiction.” N.J.S.A. 3B:31-8(a). On the other hand, if the trust instrument does not designate the site of administration, it is presumed to be New Jersey if the trust is governed by the law of New Jersey. Id. Setting aside those jurisdictional issues, the substantive law governing a trust’s administration can vary from state to state. 3
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Thus in addition to the state of jurisdiction, one must consider what state law will govern. Under New Jersey’s Trust Code, the meaning and effect of the trust terms are generally determined by (a) the law of the jurisdiction designated in the trust instrument or (b) the law of the jurisdiction that has “the most significant relationship to the matter at issue.” N.J.S.A. 3B:31-7. That substantive law would govern a dispute or proceeding involving a trust’s administration even if it is not the law of the forum state that maintains jurisdiction over the dispute. That may require consideration of law of more than one state as “the procedural law of the forum state applies even when a different state’s substantive law must govern.” N. Bergen Rex Transp., Inc. v. Trailer Leasing Co., 158 N.J. 561, 569 (1999); In re May 1, 1992 Mark Family Trust, 2016 WL 4145851 (App. Div. 2016). Thus, for example, if a trust, by its terms, were governed by the law of New York, but its principal place of administration were in New Jersey, a New Jersey court might apply New York law to construe its terms. In doing so, however, it would only consider evidence admissible under the procedural law of New Jersey. In other words if a grantor, or her trustee, has concerns about the prospect of litigation in the future, she may wish to consider both the forum of jurisdiction as well as the governing substantive law. For example, after a grantor’s death, a family member could challenge the validity of a trust created and funded during the grantor’s lifetime under the premise that it is the product of undue influence. Once the contestant establishes the existence of a confidential relationship between the grantor and proponent of the instrument, under New Jersey law, the burden of proof is then shifted to the proponent to establish the absence of undue influence. Pascale v. Pascale, 113 N.J. 20, 31 (1988). And the proponent’s burden of persuasion will be high – she must meet her burden by clear and convincing evidence. Id. Thus New Jersey law could have a profound impact on such litigation – the proponent of the instrument may face a more challenging position in New Jersey compared to another state (albeit, there are other states that apply similar mechanisms to adjudicate such disputes). On the other hand, if a trust is challenged under the premise that the grantor lacked the requisite mental capacity to execute it, and the trust was revocable when it was created, the proponent need only establish that the grantor maintained a minimal level of mental capacity when it was signed (the same capacity required to sign a will). N.J.S.A. 3B:31-42; Gellert v. Livingston, 5 N.J. 65, 73 (1950). Thus it may be more difficult in New Jersey than in other states for a litigant to challenge a revocable trust on capacity grounds. To deter litigation, a grantor may wish to include an “in
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terrorem” (no contest) clause in the trust instrument. The enforceability of such a clause, however, may depend upon the applicable law. In New Jersey, an in terrorem clause is unenforceable so long as the contestant had “probable cause” for instituting his or her challenge. N.J.S.A. 3B:3-47; N.J.S.A. 3B:3-33.1(b). In contrast, in terrorem clauses are generally enforced in New York, whether or not the contestant possessed probable cause to challenge the trust, subject to certain statutory exceptions. EPTL 3-3.5; Tumminello v. Bolton, 59 A.D.3d 727 (NY 2d Dep’t 2009); Matter of Stralem, 181 Misc.2d 715, 715 (NY Surr. Ct. Nassau Cty. 1999). In addition to trust contests, disputes may arise regarding the construction of a trust, and the applicable procedural and substantive law may have an impact on such a dispute. New Jersey, for example, takes a more liberal approach than some other states when it comes to the admission of evidence. A New Jersey court may review extrinsic evidence (i.e., evidence outside the four corners of the instrument) to evaluate the probable intent of the grantor. Fidelity Union Trust Co. v. Robert, 36 N.J. 561, 573 (1962). This may be true even if the instrument appears unambiguous on its face. Id. In other states, such as New York, extrinsic evidence can only be admitted if doubt or ambiguity exists within the four corners of the instrument. In re Chase Manhattan Bank, 6 N.Y.3d 456, 460 (2006). Thus if a grantor is concerned a litigant might seek to contradict the intent that she expressed in the instrument, she may wish to consider whether she would want extrinsic evidence admissible in such a dispute. Of course there are many other disputes that may arise in the administration of a trust. Perhaps it is more difficult to remove a trustee under the law of one state versus another. Perhaps one jurisdiction applies more stringent rules than another when evaluating the prudence of trust investments. Other considerations may be warranted. The courts may operate differently in one state versus another. Perhaps it is easier for a plaintiff to pursue a particular claim in New Jersey versus in another jurisdiction, or vice versa. Perhaps a grantor, concerned about potential litigation, may wish to select a jurisdiction where it is procedurally more burdensome to pursue a claim or where a claim cannot be resolved expediently. Bearing all of this in mind, in some circumstances, it may be possible to move the situs of a trust after it is created. Perhaps the trust instrument specifically empowers the trustee to move the situs (that authorization is often incorporated in modern estate planning documents). But in the absence of such affirmative authority under the trust instrument, mechanisms exist under New Jersey law, allowing one to effectuate transfer of a trust’s principal place of administration. For example, under New Jersey’s Trust Code, a trustee can potentially do so by providing notice to the “qualified beneficiaries” (as defined under N.J.S.A. 3B:31-2 and 3B:31-10) of a
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proposed transfer within 60 days of initiating such transfer. N.J.S.A. 3B:31-8(d). Of course, in determining whether to create a trust that is subject to jurisdiction or governing law of a particular state or in determining whether to move the trust situs or change its governing law, there are a host of non-litigation issues and risks that should be considered. For example, the law of some states allow for significant asset protection, even if the trust is self-settled, but the majority of states do not. Some states, such as New Jersey, have eliminated the rule against perpetuities, while others have not. Perhaps most significant to many, some states impose tax on a trust’s income, while others do not. In selecting a trust’s situs and governing law, estate planners often focus their attention exclusively on these non-litigation issues. The possibility of litigation, however, can be an equally important consideration. Thus depending on the priorities of the grantor and the risks perceived, one should consider the substantive and procedural law that might govern such a dispute and whether it makes sense to avoid or target the law of a particular jurisdiction. Reprinted with permission from the March 22, 2021, issue of the New Jersey Law Journal. Further duplication without permission is prohibited. All rights reserved. © 2021 ALM Media Properties, LLC.
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CFTC and SEC Perspectives on Cryptocurrency and Digital Assets Volume I: A Jurisdictional Overview By: Stephen M. Humenik, Cheryl L. Isaac, Keri E. Riemer and Christine Mikhael Attorneys from K&L Gates LLP explore the question of Federal regulation of cryptocurrencies and digital assets in the financial markets, and whether the Securities and Exchange Commission or the Commodities and Futures Trading Commission will take the lead. I. Introduction The rise of cryptocurrencies and digital assets in the financial markets, including the investment management industry, has given rise to a crucial question: which federal regulator - the SPRING 2022
Securities and Exchange Commission (SEC) or the Commodities and Futures Trading Commission (CFTC) will be primarily responsible to regulate the use of crypto and crypto-related activities? SEC Chair Gary Gensler has stated that “[crypto] products are subject to the securities laws and must work within our securities regime,” while then CFTC Commissioner Quintenz expressed that “the SEC has no authority over pure commodities or their trading venues, whether those commodities are wheat, gold, oil…or crypto assets.” In this article, we provide a high-level overview of the SEC’s and CFTC’s current jurisdiction over and treatment of crypto, and discuss recent enforcement actions involving crypto and the potential significance thereof to other market participants. 1. SEC Jurisdiction The SEC has the authority to govern “securities”4, which has been defined to include, among other things “investment contracts.” Notably, “currency” is not a security. To the extent that a form of a digital asset is determined to be a note, investment contract or other type of security, it would be subject to SEC oversight and applicable securities laws. Whether a digital asset is considered an investment contract depends on the test outlined by the U.S. Supreme Court in SEC v. W.J. Howey. In this case, the Supreme Court found that an “investment contract” exists where (i) there is the investment of money; (ii) in a common enterprise; (iii) with a reasonable expectation of profits to be derived; (iv) from the efforts of others. The Court emphasized that the determination of whether an investment contract exists lies in the 6
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circumstances surrounding the contract and the manner in which it is offered, sold, or resold. The Howey test was emphasized by then Chair Clayton in his February 2018 speech before the Senate Banking Committee on digital assets.6 Later that year, then Director of the SEC’s Division of Corporate Finance William Hinman applied the Howey7 test to crypto. Like the Court, he emphasized that for digital assets specifically, the SEC looks to the nature of the transaction rather than the item being sold - and whether the Howey factors are present - to determine whether there is an investment contract. He noted that digital assets that are sold “as part of an investment; to non-users; by promoters to develop the enterprise – can be, and, in that context, most often is, a security – because it evidences an investment contract.”8 He further noted that networks on which a coin is sufficiently decentralized, that is where the purchasers no longer reasonably expect a person to carry out essential managerial efforts, do not represent investment contracts. It is important to note that the SEC’s views on its ability to regulate crypto have not changed in recent years. SEC Chair Gensler continues to urge legislators to grant the SEC more scope to oversee crypto in an effort to enhance investor protection. He has also stated, ““It doesn’t matter whether it’s a stock token, a stable value token backed by securities, or any other virtual product that provides synthetic exposure to underlying securities. These products are subject to the securities laws and must work within our securities regime…”9 2. CFTC Jurisdiction In contrast to the SEC, the CFTC has full regulatory authority over derivatives transactions (including swaps, futures, and options), and more limited authority to regulate fraud and manipulation in commodities markets. The CFTC made its first official statement on its jurisdiction over digital assets in 2015. Later, in 2016, the CFTC cemented its position in an enforcement action stating that, “bitcoin and other virtual currencies are encompassed in the definition [of commodity] and properly defined as commodities, and are subject as a commodity to the applicable provisions of the [Commodity Exchange] Act and [CFTC] Regulations.10 Then Chair Heath Tarbert expanded upon this definition in October of 2019 stating that, “it is my view as Chairman of the CFTC that Ether is a commodity.”11 Additionally, in a recent case in the Southern District of New York, the court found that “Bitcoin, Ether, Litecoin, and Tether tokens, along with other digital assets, are encompassed within the broad definition of “commodity” under Section 1a(9) of the [Commodity Exchange] Act.”12 As a result, it is widely accepted that established and broadly decentralized virtual currencies, like Bitcoin and Ether, are “commodities” and not currencies. Efforts to categorize these
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cryptocurrencies or others as “currencies” generally will not withstand regulatory scrutiny because they are goods exchanged in a market for uniform quality and value and thus fall both within the common definition of commodity and the Commodity Exchange Act’s (CEA) definition of commodity.13 It is important to note that the “jurisdictional authority of CFTC to regulate virtual currencies as commodities does not preclude other agencies from exercising their regulatory power when virtual currencies function differently than derivative commodities.”14 Even though the CFTC has determined that virtual currencies are commodities, the CFTC’s jurisdiction over virtual currency markets is limited to policing fraudulent and manipulative activities in interstate commerce. Beyond this type of enforcement authority, the CFTC does not generally oversee virtual currency transactions or exchanges that do not involve margin, leverage, or financing, and cannot, for example, require a spot crypto exchange to register with the CFTC. As a result of the above, the CFTC is said to have “enforcement jurisdiction” over cryptocurrency and digital assets, but not “registration jurisdiction.” A spot cryptocurrency product is generally a product that results in actual delivery of the cryptocurrency within a particular market’s spot delivery period. An example of a U.S.-based spot market is Coinbase. Despite the CFTC’s lack of registration jurisdiction over spot markets, to the extent that a cryptocurrency product in a spot market provides for margin or leverage and is offered to retail customers, the product would generally be considered a futures contract subject to CFTC jurisdiction.15 Specifically, to the extent that spot trading provides for margin and is offered to retail U.S. persons, it falls under the CFTC’s broader and more onerous registration jurisdiction.16 Additionally, there is further heightened regulatory scrutiny with regards to margined or leveraged products. Recently, CFTC acting Director of Enforcement Vincent McGonagle stated, “In the digital asset space, we’ve brought several actions against entities where they’re offering digital assets, Bitcoin or others on a margin or finance basis…and those products should be on an exchange.”17 CFTC Chair Rostin Behnam recently stated that, “I look forward to working with this [Senate Agriculture] Committee to reexamine – and, if appropriate, expand – the CFTC’s authority to ensure both the benefits and promise of the emerging digital asset market and the underlying technology can be harnessed without undue harm to customers and financial market stability.”18 Chair Behnam also stated during the confirmation hearing that the recent enforcement actions were the “tip of the iceberg.” This means there are several other enforcement cases in the CFTC’s docket, which will become public upon the filing of such enforcement cases.
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II. SEC and CFTC Enforcement Actions 1. SEC i. Ripple Labs, Inc. In 2020, the SEC initiated an enforcement action against Ripple Labs Inc. (Ripple), alleging that the sale of Ripple’s digital token (XRP), worth a notional amount of approximately US$1.3 billion, was an unregistered securities offering.19 The SEC alleged that Ripple distributed billions of dollars’ worth of XRP as employee compensation in lieu of cash in order to finance its business. Ripple provides block chain-based networks that facilitate low-cost payments between financial institutions. XRP is a digital asset that is used to represent the transfer of value across networks. Specifically, the SEC claims that XRP is a security whose offer and sale can be made only pursuant to a statutory prospectus and an effective registration statement, and that because Ripple did not file a registration statement its investors have a rescission right. The SEC alleged that XRP met the Howey test by claiming that “the principal reason for anyone to buy XRP was to speculate on it as an investment,” that Ripple reflected a common enterprise, and that investors reasonably expected to profit from those efforts. It also claims that, because Ripple did not provide a registration statement, it made material misstatements and omissions of information that is required of securities issuers when soliciting public investment. While the case is still ongoing, in January 2022, the judge presiding over the case did grant Ripple’s request for privileged SEC documents, which reflect the SEC’s determination on its classification of XRP as a security. The final outcome of the Ripple case, whether it will result in XRP’s classification as a security or not, will have significant implications for the SEC’s jurisdiction over digital assets. Along with the BlockFi action, below, the Ripple determination (when final) is expected to provide much-needed clarity to crypto market participants on when a digital asset would be considered a “security” and subject to much more onerous regulation by the SEC. We note, however, that the Ripple case is currently at the trial court level, and any decision by the court could be appealed and overturned, so it may be some time before we have a conclusive determination on XRP’s status. ii. BlockFi Lending LLC In February 2022, the SEC charged BlockFi Lending LLC (BlockFi) for failing to register the offers and sales of BlockFi Interest Accounts (BIAs), under the Securities Act of 1933 (Securities Act).20 In addition, the SEC stated that BlockFi met the definition of “investment company” set forth in Section 3(a)(1)(C) of the Investment Company Act of 1940 (1940 Act), for at least a period of time, but failed to register with the SEC as it was required to do, because it issued securities and acquired securities. The failure of an investment company to register with the SEC (absent an exemption or exclusion) has serious conseSPRING 2022
quences, including that all of its contracts are unenforceable. First, the SEC determined that BIAs were sold as securities (determined in accordance with the Howey test) because (i) BlockFi promised BIA investors a variable interest rate, which was determined by BlockFi on a periodic basis, in exchange for crypto assets loaned by the investors, who could demand that BlockFi return their loaned assets at any time, (ii) investors in the BIAs had a reasonable expectation of obtaining a future profit from BlockFi’s efforts in managing the BIAs based on BlockFi’s statements about how it would generate the yield to pay BIA investors interest, and (iii) investors also had a reasonable expectation that BlockFi would use the invested crypto assets in BlockFi’s lending and principal investing activity, and that investors would share profits in the form of interest payments resulting from BlockFi’s efforts. As a result, the SEC found BIAs to constitute investment contracts under the Securities Act. By offering and selling the BIAs to the general public to obtain crypto assets for the general use of its business and promote the BIAs as an investment, the SEC determined that BlockFi offered and sold securities, thereby acting as an issuer, without filing a registration statement or qualifying for an exemption from the registration requirements, in violation of the 1940 Act. Additionally, the SEC found that, for a period of almost two years, BlockFi’s activities and holdings deemed it to be an “investment company” under Section 3(a)(1)(C) of the 1940 Act. This section generally defines an “investment company” as being any issuer that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire “investment securities” (as defined in Section 3(a)(2) of the 1940 Act) having a value of over 40% of the value of the issuer’s total assets on an unconsolidated basis. In the SEC’s view, the fact that BlockFi lent crypto assets to institutional and corporate borrowers, lent U.S. dollars to retail investors, and obtained value by offering and selling BIAs into equities and futures, in addition to its substantial holdings of investment securities (representing more than 40% of the value of BlockFi’s total assets on an unconsolidated basis) caused BlockFi to be an unregistered investment company. As a result, the SEC alleged that BlockFi violated Section 7(a) of the 1940 Act by engaging in interstate commerce while failing to register as an investment company with the Commission. BlockFi agreed to pay a US$50 million penalty to settle the SEC charges and ceased its unregistered offers and sales of BIAs. BlockFi further agreed to attempt to bring its business within the provisions of the 1940 Act within 60 days. BlockFi’s parent company recently announced that it intends to register under the Securities Act of 1933 the offer and sale of a new lending product.21 Although Blockfi is the first case of its kind brought by the SEC with respect to a crypto lending platform, it may be a harbin8
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ger of things to come, particularly as the SEC has expressed eagerness to regulate the crypto market and recently almost doubled the size of the Division of Enforcement’s Crypto Assets and Cyber Unit. On 7 September 2021, Coinbase Chief Executive Officer (CEO) Brian Armstrong announced that the company is under investigation by the SEC due to its cryptocurrency lending practice. Mr. Armstrong noted, that, “They [SEC] refuse to tell us why they think it’s a security, and instead subpoena a bunch of records from us (we comply), demand testimony from our employees (we comply), and then tell us they will be suing us if we proceed to launch, with zero explanation as to why.” This further demonstrates the point that the cryptocurrency and digital asset markets are under intense scrutiny from regulators.22 Further, similar investigations and enforcement actions are known to be pending against Celsius Network LLC, Gemini Trust, and Voyager Digital with respect to similar interest bearing account offerings.23 As the SEC continues to enforce its jurisdiction over the digital asset market, we will continue to keep you apprised of noteworthy enforcement and regulatory actions. 2. CFTC The CFTC has initiated a number of enforcement actions related to crypto and has particularly been focused on exchanges that offer crypto derivatives to U.S. persons and are not registered with the CFTC. For instance, in October 2020, the CFTC charged HDR Global Trading Limited, 100x Holding Limited, ABS Global Trading Limited, Shine Effort Inc. Limited, and HDR Global Services (Bermuda) Limited’s (BitMEX) owners with illegally operating a cryptocurrency derivatives trading platform and with anti-money laundering (AML) violations due to providing U.S. persons with crypto derivatives. Several owners of BitMEX also were charged with related criminal offenses. BitMEX replaced its leadership team after the charges were announced, and its new CEO has recently stated that BitMEX plans to provide spot trading, brokerage, and custody services. On 11 August 2021, the CFTC announced a consent order in the BitMEX case. Under the consent order, BitMEX paid a US$100 million civil monetary penalty (US$50 million to CFTC and US$50 million to the Financial Crimes Enforcement Network) and agreed to stop offering futures or other related crypto commodity contracts in the United States until it secures appropriate licensure from the CFTC. BitMEX also agreed to establish sufficient “know your customer” and AML procedures.24 Similarly, the CFTC had previously brought action against Laino Group Limited (PaxForex), an international company registered in Saint Vincent and Grenadines, which operated PaxForex and alleged that its information technology infrastructure had been deployed to data centers in New York and London.25 In June 2021, the Southern District of Texas SPRING 2022
entered an order of final judgment against PaxForex for violating CEA provisions regarding retail investors and for offering unregistered leveraged transactions in cryptocurrencies.26 Specifically, the order notes that the website format solicited U.S. customers by providing customers with a drop down menu with an option of selecting the United States as the customer’s country of residence.27 The PaxForex website now states that the information on its website is not intended to be addressed to U.S. citizens. Additionally, on 18 September 2021, the CFTC settled charges against Payward Ventures, Inc. d/b/a Kraken (Kraken) for illegally offering margined retail commodity transactions (which are presumptively treated as futures contracts unless certain mitigating factors exist) in digital assets, including Bitcoin, and for failing to register as a futures commission merchant (FCM). Specifically, the CFTC alleged that Kraken offered margined digital assets to U.S. customers who were not eligible contract participants, on an exchange that was not registered as a derivatives contract market with the CFTC. In the program, Kraken supplied digital assets to customers when they purchased the assets using margin. Kraken then required the customers to exit their positions and repay the assets received to trade on margin within 28 days. Customers could not transfer assets away from Kraken until they satisfied their repayment obligation, and Kraken could force liquidation if repayment was not made within 28 days. As a result, the CFTC ordered that Kraken pay a US$1.25 million civil monetary penalty and cease and desist from further CEA violations.28 In addition, on 15 October 2021, the CFTC issued an order against iFinex Inc., BFXNA Inc., and BFXWW Inc. (d/b/a Bitfinex) for violations of Sections 4(a) and 4(d) of the CEA. Specifically, the CFTC alleges that Bitfinex offered spot and leveraged, margined, or financed trading in Bitcoin, Ether, and Tether to U.S. customers. The CFTC further alleges that the respondents transacted in retail commodity transactions without registering as an FCM. Perhaps most significantly, the CFTC announced that the Tether stablecoin is a “commodity,” reaffirming that it has enforcement jurisdiction over this type of cryptocurrency. The CFTC ordered that Bitfinex pay a US$1.5 million civil monetary penalty and required Bitfinex to implement further systems to prevent unlawful retail commodity transactions.29 The CFTC has also initiated enforcement actions related to tokens. On 15 October 2021, the CFTC settled charges against Tether Limited, Tether Operations Limited, and Tether International Limited (d/b/a Tether) for violating Section 6(c)(1) of the CEA by making misrepresentations to customers regarding its U.S. dollar-denominated stablecoin Tether. Specifically, the CFTC alleged that Tether made misrepresentations to U.S. customers that Tether maintained sufficient fiat reserves to back every one of its stablecoins in circulation “one-to-one” with the “equivalent amount of corresponding fiat currency” held in reserves by Tether, and that Tether would undergo 9
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routine, professional audits to demonstrate that it maintained “100% reserves at all times.” The CFTC alleges that in actuality, Tether failed to maintain fiat currency reserves in accounts in Tether’s own name or in an account titled and held “in trust” for Tether to back every U.S. dollar tether token in circulation. The CFTC has ordered that Tether pay a US$41 million fine.30
To view all formatting for this article (eg, tables, footnotes), please access the original here. Stephen M. Humenik, Cheryl L. Isaac, Keri E. Riemer and Christine Mikhael
Finally, in February 2021 Coinbase reported that it was under investigation by the CFTC for alleged reckless false, misleading, or inaccurate reporting as well as wash trading by a former employee. On 19 March 2021, Coinbase agreed to a settlement order with the CFTC in which Coinbase did not admit or deny wrongdoing and agreed to pay US$6.5 million. The chart above summarizes certain CFTC enforcement actions. III. Conclusion Unlike the earliest days of Bitcoin trading, cryptocurrencies and digital assets have now caught the eye of federal regulators and are subject to a much greater level of regulatory scrutiny. Both the CFTC and SEC are asserting their jurisdiction in this space, and in many cases, additional clarity is needed to understand whether a digital asset should be considered a commodity (subject to the CFTC’s enforcement authority), or a security (subject to the SEC’s jurisdiction). In addition, even with this clarity, a related question persists on whether the SEC and CFTC collectively have sufficient regulatory authority in order to properly regulate crypto markets, or if congressional action is needed. As crypto regulation evolves, market participants will have much greater certainty, and in all likelihood a new regulatory regime involving both the SEC and CFTC. As the SEC and CFTC continue to enforce their jurisdiction over the digital asset market, we will continue to keep you apprised of all noteworthy enforcement actions and regulatory updates.
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Green Book Proposals Related to Estate and Gift Tax By: Samuel Olchyk and Allison R. Church Samuel Olchyk and Allison R. Church from Venable LLP highlight key estate and gift tax proposals from the Treasury Department’s General Explanation of the Administration’s Fiscal Year 2023 Revenue Proposals – the 2023 Treasury Green Book. On March 28, the Biden administration released its budget recommendations for fiscal year 2023 (which begins this October 1). The budget calls for nearly $5.8 trillion in spending during the upcoming fiscal year, offset by $4.6 trillion in revenues. The revenue proposals are described in the Treasury Department’s General Explanation of the Administration’s Fiscal Year 2023 Revenue Proposals (commonly referred to as the Treasury “Green Book”), which accompanied the budget recommendations. A number of these items affect estate and gift tax-related issues. Here are a few key items to note regarding these proposals.
#1. The Green Book incorporates the Build Back Better Act that was passed by the House of Representatives in 2021 in the baseline. Typically, the spending and revenue proposals reflect an administration’s fiscal priorities for the upcoming fiscal year. But that is not necessarily the case this year. In light of the ongoing discussions surrounding last year’s House-passed “Build Back Better” legislation, the Green Book states that the administration’s proposed revenue proposals utilize a “baseline that incorporates all revenue provisions of Title XIII of H.R. 5376 (as passed by the House of Representatives on November 19, 2021) [other than the SALT proposal].” In other words, this budget package assumes the enactment of the revenue provisions in the “Build Back Better Act”; the revenue proposals in the Green Book are additional revenue proposals. Many of these proposals were described in last year’s Green Book (for fiscal year 2022) and were considered but not included in the House-passed Build Back Better Act. #2. The Green Book would alter the taxation of capital gains. The proposals would treat death or the gift of appreciated property as a realization event, resulting in capital gains tax being incurred immediately upon such an event. Each individual would receive a $5 million lifetime exclusion. Additionally, the Green Book would tax capital gains for highincome earners (over $1 million) at ordinary income rates and
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would impose a minimum 20% tax on total income (including unrealized capital gains) for taxpayers with wealth over $100 million. #3. The Green Book would limit the duration of GST exemption. Under current law, allocating sufficient generation-skipping transfer (GST) tax exemption to a trust makes the trust perpetually GST-exempt. These proposals would limit the duration of GST exemption for trusts based on the generation of the beneficiaries of the trust, generally allowing GST-exempt distributions only to beneficiaries who are no more than two generations below the transferor and those beneficiaries who were alive at the creation of the trust. Pre-enactment trusts would not be grandfathered in under this new regime, but rather would be treated as though they were created on the date of enactment.
Although it is unclear at this point which, if any, of these proposals will be enacted, we continue to recommend that clients engage in planning to make use of their expanded estate, gift, and GST tax exemptions before it is too late. Please contact us if you would like to discuss the Green Book proposals, gifting strategies, or your estate plan in general. Venable LLP - Samuel Olchyk and Allison R. Church
#4. The Green Book would alter the tax treatment of grantor trusts. Under current law, the creator of a grantor trust is treated as the owner of the trust assets for income tax purposes, which means that the grantor can engage in transactions with his or her grantor trust without triggering a realization event and can pay the income taxes of a grantor trust without making a taxable gift. The Green Book proposals would dramatically change the treatment of grantor trusts (other than revocable grantor trusts) by treating transfers to and from such trusts that occur on or after the date of enactment as recognition events. Furthermore, the Green Book would treat the payment of income taxes on behalf of a grantor trust as a gift (for trusts created on or after the date of enactment). #5. The Green Book targets grantor retained annuity trusts (GRATs). GRATs allow the excess of the actual rate of return on gifted assets over the expected rate of return set out in the so-called Section 7520 rate published monthly by the Treasury to pass to beneficiaries with little or no taxable gift. The Green Book proposals would cripple the efficiency of GRATs by requiring the remainder interest (i.e., the taxable gift portion) in a GRAT to have a minimum value of the greater of 25% of the value of the assets contributed to the GRAT or $500,000; requiring GRATs to have a minimum term of 10 years; and prohibiting tax-free asset swaps with GRATs. #6. The Green Book would require increased use of electronic filing of certain tax returns. Specifically, the Green Book would require electronic filing of estate tax returns (Form 706) , gift tax returns (Form 709), and trust income tax returns (Form 1041) for all related individuals, estates, and trusts with assets or gross income of $400,000 or more in any of the three preceding years.
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Estate Administration: The Digital Assets Dilemma By: Laura Walliss Laura Walliss provides an introduction to the laws in the UK concerning the growing issues surrounding estate administration of digital assets. The rapid increase in the range and prevalence of digital assets over the past few years is creating an ever-widening gap between the technologies available to the public and the lumbering legal systems struggling to catch up. Legislation governing vital legal considerations relating to those assets – such as, ownership, access and succession – has yet to arrive. In the void, personal representatives (PRs) and their legal advisers administering the estate of a deceased person are left trying to navigate uncharted territory and fulfil their traditional duties and responsibilities, without the necessary legal framework in place to enable them to do so.
One of the areas in which the lack of digital asset legislation causes the most practical difficulty, is in relation to accessing online accounts after death. With no legal framework in the UK requiring a deceased person’s PRs to be permitted access to their digital assets, access is currently governed by the terms and conditions of the service provider of the relevant digital asset. This is problematic for two reasons. First, these terms and conditions were usually not written with the death of the account-holder in mind and often do not provide adequately (or at all) for the situation. Secondly, digital assets service providers are often based in the United States, which has stringent privacy laws. In fear of falling foul of these laws, service providers are often loathe to allow access to anyone other than the original account-holder, with the vast majority prohibiting the customer sharing their account password or assigning their rights under the contract. This can cause real practical difficulties during an estate administration. Section 1 of the Computer Misuse Act 1990 makes it an offence (amongst other things) to access an online account after someone’s death without authority. In the case of online accounts, this authority must come from the service provider and, for the reasons outlined above, this is not usually forthcoming. In some cases, the situation is improved where the deceased has been able to engage with these issues during their lifetime.
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Although there is no legislation to assist, some of the bigger providers such as Google, Facebook and Apple have put in place their own measures to facilitate the situation postdeath. However, these often do not go far enough and are not available at all when it comes to many of the smaller service providers. Where lifetime planning has not been able to satisfactorily deal with access issues post-death (or has not been undertaken at all), PRs are placed in a difficult position. Section 25 of the Administration of Estates Act 1925 places a duty on PRs to collect in all the assets of the deceased (including digital assets) and administer them according to law, but how can they do this when access to the account is forbidden? There is often no physical evidence that a deceased held certain digital assets and accessing a digital bank account or an email account may be essential to fully understanding what is in the estate at all, let alone then collecting in those assets. The choice for PRs then becomes an unpalatable one: break the law; fail to administer the whole estate properly (and thus open themselves up to potential claims from beneficiaries); or seek access to accounts by way of court order which would be disproportionately time-consuming and costly, given the digital assets held in most estates. This is an incredibly unsatisfactory situation, both for the PRs and those who advise them. There may, however, be some hope on the horizon. In January of this year, Ian Paisley MP introduced a private members’ bill, which aims to address the question of access to an individual’s digital assets after their death. The bill’s second reading is scheduled for 6 May. As currently drafted, the bill proposes that the default position would be that a deceased person’s next of kin would have automatic access to any digital platforms held on the deceased’s devices. While this proposal could be problematic without proper safeguards – in terms, for example, of protecting the deceased’s privacy after their death – it is nevertheless reassuring (and overdue) to see this issue receiving some parliamentary time and attention. Whether or not the bill will eventually become law, and in what form, remains to be seen, but everyone with digital assets, not to mention the lawyers trying to advise them, would be better served by a comprehensive set of legislation governing this area – sooner, rather than later. This article was first published on Legal Futures and can be read online here. SPRING 2022 14
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Spotlight: Wealth Structuring and Regulation in Canada By: Margaret R. O’Sullivan and Marly J. Peikes O’Sullivan Estate Lawyers firm in Toronto, Ontario, provide an overview of major estate planning techniques currently utilized in Canada, and discuss issues which are both very familiar and very different from what estate planners face in the United States. Wealth structuring and regulation i. Common vehicles for wealth structuring Trusts and holding companies are perhaps two of the most common vehicles used in wealth structuring.
TrustsIncome splitting Trusts can be established inter vivos or by will. Inter vivos trusts are often used to split income with family members, where the trust earns income and acts as a conduit to allocate income, including taxable capital gains, among beneficiaries who are subject to lower rates. Effective planning involves careful attention to the possible application of the attribution rules, which can attribute income back to a high-tax rate taxpayer. Trusts used in conjunction with an ‘estate freeze’ Trusts are also commonly used in conjunction with an estate freeze to hold growth property for future generations, such as common shares of a private company that are expected to grow in value, and thereby defer taxation on any gains until the future rather than until the death of the founder. This can achieve significant tax savings. The use of a trust can allow for control of the timing of distribution of property, for selection of beneficiaries and for general wealth protection purposes. Generally, a fully discretionary trust is used for such purposes. Trusts as will substitutes Trusts are also increasingly used as will substitutes, in particular ‘alter ego’ and ‘joint partner’ trusts that are
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specifically defined under Canadian income tax legislation and allow persons aged 65 and over, provided certain conditions are met, to roll over capital property on a taxdeferred basis, as opposed to triggering capital gains. Alter ego and joint partner trusts are often used to provide for succession to property on the death of the spouse or spouses as a substitute to a will. They may offer benefits such as: 1. avoiding expensive court fees, probate taxes and the protracted court probate process; 2. more privacy than a will; 3. ensuring capital succession to property on death; and 4. protection against estate litigation, including will challenges and other claims arising on death. Trusts may also offer an effective and sophisticated vehicle to manage assets on incapacity as a primary alternative to a power of attorney. Use of testamentary trusts for income splitting and other benefits Testamentary trusts (trusts created under a will) have been used to provide for income splitting after the testator’s death. Certain estates and testamentary trusts are taxed at the graduated rates applicable to individuals, whereas trusts established during lifetime are subject to the top marginal tax rates applicable to individuals. Prior to 2016, testamentary trusts allowed for income splitting between the trust and one or more beneficiaries, which resulted in significant tax savings. However, commencing in 2016, testamentary trusts with exceptions for graduated rate estates and for qualified disability trusts are subject to the top tax rate applicable to individuals and, consequently, the above tax benefits have been eliminated, although it will still be possible to ‘sprinkle’ income among a group of beneficiaries of a discretionary testamentary trust if the trust terms permit. In addition, the use of a testamentary trust may provide for capital succession planning and can safeguard against beneficiaries’ matrimonial and creditor claims, among other benefits. Multiple wills used to minimise probate fees Multiple wills are increasingly used in certain provinces to minimise estate administration tax and probate fees. For example, in Ontario, estate administration tax is approximately 1.5 per cent of the value of estate assets. Assets are often segregated under two wills: a primary will and a secondary will. Assets that generally do not require a probated will to administer by way of proof of executors’ authority to third parties, such as financial institutions and purchasers of land property, are segregated under a secondary will. The secondary will would typically include private company shares, family loans, tangible personal property and beneficial trust interests. Only the primary will is typically probated,
and applicable tax or court fees are then based on the value of the assets passing under the primary will, which is generally expected to be a more modest asset value base. Holding companies Holding companies are a common feature of Canadian estate planning. They are often used to hold investment assets, including US securities and certain other US situs assets to protect against exposure to US estate tax, to defer tax on active business income where shares of an active business are held by the holding company, to split income, including in conjunction with use of a family trust, and for asset protection and retirement planning. Potential tax advantages of holding companies The utility of an investment holding company to earn investment income at a lower tax rate than if earned personally will depend on changing tax rates, which historically have at certain times offered tax advantages and at other times have been neutral and less advantageous. Holding companies are also used in conjunction with probate fee and estate tax minimisation strategies as outlined above. Private company shares can pass under a secondary will, which typically may not need to be probated, thereby saving fees and tax, which can be significant where the shares have a high value. There is potential for double taxation on death where assets are held in a holding company, because a deceased person will be subject to personal taxation on the deemed disposition of the shares of the holding company giving rise to possible taxable capital gains, and also the same gains may be reflected in the holding company’s underlying assets, on which tax will be paid at the corporate level on sale of the assets or wind-up of the company. It is therefore necessary to implement proper post-mortem tax planning to avoid potential double taxation on death. ii Anti-money laundering regime and new transparency requirements The Proceeds of Crime (Money Laundering) and Terrorist Financing Act came into effect in 2001. It introduced requirements for a compliance regime, record-keeping, client identification and reporting. Reporting entities must implement a compliance regime, keep certain records, obtain certain client identification and report suspicious transactions to an independent agency, the FINTRAC. Certain other financial transactions, as well as terrorist property, must also be reported. All regulated entities starting 1 June 2021 will also be required to obtain and take reasonable steps to confirm the accuracy of beneficial ownership information they obtain, and not just in certain sectors. Reporting entities include financial institutions, such as banks, trust companies, loan companies, life insurance companies, brokers and agents, securities dealers, accountants and accounting firms carrying out certain transactions, real estate brokers, and certain others. The legislation imposes harsh financial and
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criminal penalties, including imprisonment for failure to report. Reporting entities have to send large cash transaction reports to the FINTRAC when they receive an amount of C$10,000 or more in cash in the course of a single transaction, and financial entities, money service businesses and casinos have to report incoming and outgoing international electronic funds transfers of C$10,000 or more in a single transaction. In the past few years, initiatives to require company, trust and real estate transparency have been prolific on the global stage. In Canada, they form a backdrop to recent legislative proposals and changes. In 2018, the federal government introduced legislation that came into effect on 13 June 2019, which amended the Canada Business Corporations Act to require that corporations collect and keep a register of specified information regarding those who have significant control over a corporation, including registered shareholders, beneficial owners of shares and persons who have direct or indirect influence, and as a result have control over the corporation. The information is not to be publicly available, but is to be available to directors, shareholders and creditors of the corporation. In the 19 April 2021 federal budget, the government finally announced it would build and implement a publicly accessible corporate beneficial ownership registry by 2025 and has allocated C$2.1 million for such purpose. This appears to be a modest amount given the complexity, magnitude and importance of a public registry, in particular given criticism that Canada has been lax in its enforcement of its money laundering rules, and that significant funds are laundered in Canada as a result, including through shell corporations. In December 2017, the Canadian finance ministers entered into the agreement to strengthen beneficial ownership transparency, which included a commitment on the part of the provinces to make legislative changes to require provincially incorporated corporations to maintain information on beneficial owners. Some of the provinces have forged ahead with legislative changes that contain similar requirements to those under the new federal legislation, including Manitoba and Prince Edward Island. British Columbia also implemented corporate legislation on 1 October 2020, but it differs from the federal legislative changes. Saskatchewan and Nova Scotia both have bills that have been assented to but not yet proclaimed in force at the date of writing. In the autumn of 2019, Quebec began corporate transparency consultations, and in the 2020–2021 budget, the government introduced measures that would require enterprises to obtain information on beneficial owners for disclosure to the publicly accessible Registraire des enterprises du Quebec, and to make it possible to do research on an enterprise using the name and address of a natural person. A bill has since been introduced in Quebec, which passed second reading on 14 April 2021 and at the date of writing is under study by the Quebec National Committee.
On the real estate front, British Columbia’s Land Owner Transparency Act together with the Land Owner Transparency Regulation came into force on 30 November 2020, which created a new public registry for beneficial ownership of real estate in the province. Corporations, trustees and partners will be required to provide specified information on those who have a beneficial interest in land, a significant interest in a corporation that owns land or own an interest in land through a partnership, with certain restrictions. The stated intention of the registry is to prevent tax evasion, fraud and money laundering by ending anonymous or hidden ownership of real estate. The new registry opened to the public on 30 April 2021. It remains to be seen whether this initiative will head east and roll out through other Canadian jurisdictions. In Quebec, in February 2019, a regulation was published that aimed at identifying non-resident purchasers of residential property. There is speculation that this is the first step towards a tax on non-residents, as currently exists in certain designated areas of British Columbia and Ontario. In Ontario, since May 2017, additional disclosure has been required in making a real estate transfer pursuant to the Land Transfer Act, which includes disclosure of the beneficial ownership of the transferred property; however, this information is not publicly available. With respect to trusts, as previously noted, new trust reporting and disclosure rules came into effect on 1 January 2021. All Canadian resident trusts with very limited exceptions will be required to file an annual T3 trust tax and information return whether or not the trust earned income in any year. The provision of this information erodes privacy in the use of trusts and will provide substantial information to the government that was previously not available to it.
O’Sullivan Estate Lawyers - Margaret R O’Sullivan and Marly J Peikes
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FinCEN Commences Rulemaking Process to Implement AML Reporting Requirements for Real Estate Sector By: Betty Santangelo, Melissa Goldstein, Julian Wise and Hadas Jacobi1 This article discusses the U.S. Department of the Treasury’s Financial Crimes Enforcement Network’s proposal to extend Bank Secrecy Act compliance and reporting requirements to certain persons or entities involved in real estate transactions. On December 8, 2021, the U.S. Department of the Treasury’s Financial Crimes Enforcement Network (“FinCEN”) issued an Advance Notice of Proposed Rulemaking (the “ANPRM”)2 soliciting public comment on a potential proposal to extend Bank Secrecy Act (“BSA”) compliance and reporting requirements to
certain persons or entities involved in real estate transactions. The ANPRM solicits public comment on the scope of those requirements and the persons or entities to which they should apply. Affected parties may include title insurance companies, real estate agents or brokers, real estate attorneys or law firms, and settlement or closing agents, among others.3 Comments on the ANPRM are due to FinCEN by February 21, 2022.4 Real Estate Transactions and Persons Presently Subject to FinCEN Requirements The BSA implementing regulations administered by FinCEN currently require banks, non-bank residential mortgage lenders and originators (“RMLOs”), and housing-related Government Sponsored Enterprises (“GSEs”), entities typically involved in financed real estate transactions, to establish and implement certain anti-money laundering (“AML”) controls, such as maintaining an AML program and filing suspicious activity reports (“SARs”).5 Other persons involved in real estate closings and settlements are currently exempted from the requirement to establish an AML program,6 although FinCEN has used its geographic targeting order (“GTO”) authority7 to imposed specific transaction recordkeeping and reporting requirements on title insurance companies involved in “all-cash” or “nonfinanced” transactions of certain residential real estate, such as the purchase of residential real property in excess of $300,000 in limited geographic areas, such as Manhattan and Miami.8 Accordingly, certain real estate transactions, such as “nonfinanced” or “all-cash” real estate purchases outside of these
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limited areas and not involving title insurance companies, are not currently subject to the BSA’s requirements to the degree that FinCEN deems necessary to address the higher risk of money laundering that these transactions present.9 The ANPRM defines “non-financed” and “all-cash” transactions to refer to “any real estate purchase or transaction that is not financed via a loan, mortgage, or other similar instrument, issued by a bank or non-bank [RMLO], and that is made, at least in part, using currency or value that substitutes for currency (including convertible virtual currency (CVC)), or a cashier’s check, a certified check, a traveler’s check, a personal check, a business check, a money order in any form, or a funds transfer.”10 The ANPRM Proposals The ANPRM emphasizes the need for enhanced regulation to address the “systemic vulnerability of the U.S. real estate market to money laundering,”11 echoing the Financial Action Task Force’s (“FATF”)12 recurring criticism that the U.S.’s failure to regulate real estate transactions in accordance with FATF standards constitutes a significant deficiency in the U.S. AML regime.13 In the ANPRM, FinCEN attributes the U.S. real estate market’s vulnerabilities to a lack of transparency in real estate funds transfers, the attractiveness of the U.S. real estate market as an investment vehicle, and the lack of industry regulation.14 In order to best address these vulnerabilities while minimizing compliance burdens for industry participants, the ANPRM solicits public comment on the scope of any proposed rulemaking as follows: Nature of Recordkeeping and Reporting Requirements. The ANPRM proposes two avenues to potential rulemaking in this area. One approach would be to amend the GTO regulation to also permanently “require certain persons to collect, report, and retain information about specified non financed purchases of real estate.”15 The ANPRM notes that this approach “may be an appropriately tailored way to increase the transparency of the non-financed sector of the real estate market and provide law enforcement, national security agencies, and financial institutions with highly useful information.”16 The alternative approach would entail FinCEN issuing BSA implementing regulations to “certain persons involved in non-financed real estate closings and settlements,” which would likely require such persons to adopt and implement an AML/CFT program and file SARs with FinCEN.17 FinCEN seeks comments on whether one approach is preferred over the other, and whether to extend the customer due diligence requirements, which address the identification of beneficial owners of certain legal entities, to the real estate industry.18 Scope of Persons Subject to a Reporting Requirement. FinCEN seeks comment on which persons involved in non-financed real estate closings should be subject to a proposed rule, such as title insurance companies, title or escrow companies, real estate agents or brokers, real estate attorneys or law firms, or settlement or closing agents.19
Geographic Scope and Transaction Threshold. Although FinCEN stresses that adequately addressing money laundering vulnerabilities in real estate transactions requires a rule with nationwide application, it nevertheless requests input on the geographic scope of any potential rule.20 For example, short of a nationwide application, rulemaking could be limited to jurisdictions already covered by existing GTOs. Purchases by Certain Entities. FinCEN seeks comment on whether any future rulemaking should require reporting of other types of legal entities purchasing real estate, such as shell companies and trusts. The ANPRM notes that GTO reporting requirements to date have only covered corporations, limited liability companies, partnerships, or other similar business entities not listed on an exchange regulated by the Securities and Exchange Commission.21 Type of Real Estate. FinCEN requests comment on whether to address both commercial and residential real estate transactions in the same rulemaking or to “take an iterative approach, starting first with residential transactions and then later addressing commercial transactions.”22 In addition to the broader topics outlined above, FinCEN poses certain specific questions, including: (1) what due diligence is presently conducted regarding the parties to and source of funds for a transaction prior to a real estate closing; (2) what recordkeeping requirements are currently in place for real estate transactions; and (3) how to best address in any future rulemaking the use of natural persons in money laundering schemes involving real estate transactions.23 Conclusion The ANPRM signals FinCEN’s increased focus on the prevention of money laundering through the U.S. real estate market. Consequences for the real estate sector could include additional compliance costs and heightened exposure to regulatory action.
Endnotes 1. Betty Santangelo focuses her practice on white-collar criminal defense and securities/bank enforcement. A former Assistant U.S. Attorney for the Southern District of New York, she specialized in securities and commodities fraud prosecutions. Her practice includes representing financial institutions (banks, broker-dealers, mutual funds, FCMs, insurance companies, investment advisers, hedge funds and private equity funds), other corporate entities and individuals in matters brought by the U.S. Attorneys’ offices, by various regulatory agencies, including the SEC, the bank regulatory agencies, the CFTC, FINRA, international regulators and state and local prosecutors. Nationally
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recognized for her expertise in corporate compliance issues, including anti-money laundering, OFAC and FCPA, Betty’s representation of financial institutions in white collar and regulatory matters frequently draws on these areas of expertise, including advising financial institutions on their anti-money laundering/OFAC/FCPA procedures. Betty also has significant experience conducting internal investigations for these entities involving financial fraud, money laundering and other matters. In addition, she has served as an independent consultant in SEC enforcement matters examining both the NYSE and a regional brokerdealer. Melissa G.R. Goldstein focuses her practice on anti-money laundering and sanctions regulatory compliance matters. She advises banks, brokerdealers, investment advisers, funds, insurance companies and money services businesses, including those involved in global e-commerce and virtual currency, on the anti-money laundering and sanctions regulations, rules and related issues governing their investment and business activities. She has particular expertise with issues arising out of the Bank Secrecy Act, as amended by the USA PATRIOT Act, the AML Act of 2020 and the Corporate Transparency Act. Julian M. Wise is chair of the Real Estate Group, co-chair of the Task Force for Racial Justice Initiatives and a member of the firm’s Executive Committee. He has a wide breadth of experience representing institutional and non-institutional lenders, owners/operators and investors in complex commercial real estate transactions, including on the lender side, structuring and negotiation of senior and multitranched mezzanine financings, intercreditor agreements, co-lender and participation agreements, joint venture and preferred equity agreements and loan portfolio acquisitions and dispositions and restructurings, and on the owner/operator side, acquisitions, dispositions and financings of office, retail, hotel and multifamily properties. His clients include private equity firms, major financial and commercial lending institutions and developers and owners of commercial, industrial, retail, office, hotel and large-scale residential properties Hadas A. Jacobi advises on legal and regulatory issues involving money services businesses, payments companies, virtual currency businesses, funds, and other financial service providers, with a focus on Bank Secrecy Act/anti-money laundering and sanctions laws and regulations. Prior to joining SRZ, Hadas served as a Senior Assistant Deputy Superintendent in the Consumer Protection and Financial Enforcement Division of the New York State Department of Financial Services (NYDFS). 2. Advanced Notice of Proposed Rulemaking, Anti-Money Laundering Regulations for Real Estate Transactions, 86 Fed. Reg. 69,589 (Dec. 8, 2021) (to be codified at 31 C.F.R. Chapter X) [hereinafter ANPRM], available here. 3. Id. at 69,597. 4. See News Release: FinCEN Announces Extension of the Comment Period for its Real Estate Advance Notice of Proposed Rulemaking (Feb. 3, 2022), available here. 5. 31 C.F.R. Parts 1020, 1029, and 1030, respectively. ANPRM, 86 Fed. Reg. at 69,592. 6. ANPRM, 86 Fed. Reg. at 69,592. 7. FinCEN recently issued a final rule clarifying its authority to issue GTOs under 31 U.S.C. § 5326(a), which went into effect on November 15, 2021. See Final Rule, Orders Imposing Additional Reporting and Recordkeeping Requirements, 86 Fed. Reg. 62,914 (Nov. 15, 2021) (codified at 31 C.F.R. § 1010.370), available here. The Final Rule clarifies that FinCEN’s authority to issue GTOs extends to “nonfinancial trade[s] or business[es]” within a specific geographic area, and tracks updated language in the BSA to reflect that FinCEN’s GTO authority extends to all transactions involving the “transfer of funds (as the Secretary may describe in such order),” thereby clarifying that covered transactions are not limited to the transfer of U.S. currency. Final Rule, 86 Fed. Reg. at 62,915. 8. The existing GTOs require title insurance companies to identify the natural persons behind the legal entity used to purchase residential real estate without a bank loan or similar form of external financing
(e.g., the individual responsible for representing the legal entity and the 25% or more beneficial owners of such legal entities), and cover the following geographic areas: California (San Diego, Los Angeles, San Francisco, San Mateo and Santa Clara Counties); Florida (MiamiDade, Broward and Palm Beach Counties); Hawaii (City and County of Honolulu): Illinois (Cook Couty); Massachusetts (Suffolk and Middlesex Counties); Nevada (Clark County) New York (Boroughs of Brooklyn, Queens, Bronx, Staten Island and Manhattan): Texas (Bexar, Tarrant and Dallas Counties); and Washington (King County). See, e.g., Geographic Targeting Order (Nov. 15, 2018), available here; Geographic Targeting Order (Aug. 22, 2017), available here; Geographic Targeting Order (July 27, 2016), available here. 9. ANPRM, 86 Fed. Reg. at 69,595. 10. Id. at 69,589 n.1. 11. Id. at 69,591. 12. FATF is the global standard setter for combatting money laundering, terrorism financing, and proliferation finance. See https://www.fatf-gafi. org/. 13. ANPRM, 86 Fed. Reg. at 69,590-91. See also FATF, Anti-Money Laundering and Counter-Terrorist Financing Measures in the United States: Mutual Evaluation Report (Dec. 2016) at 39, available here (describing “the vulnerabilities of the financial sector” in the U.S. as constituting a “significant threat”). Although FinCEN first issued an ANPRM on AML/CFT program requirements in 2003 for “persons involved in real estate closings and settlements,” FinCEN never finalized this rulemaking. See Advanced Notice of Proposed Rulemaking, AntiMoney Laundering Program Requirements for Persons Involved in Real Estate Closings and Settlements, 68 Fed. Reg. 17,569 (Apr. 10, 2003), available here. See also ANPRM, 86 Fed. Reg. at 69,593. 14. ANPRM, 86 Fed. Reg. at 69,593. 15. Id. at 69,597. 16. Id. 17. Id. 18. FinCEN is currently in the rulemaking process to implement the new beneficial ownership reporting requirements imposed pursuant to the Corporate Transparency Act, enacted into law as part of the National Defense Authorization Act for Fiscal Year 2021. See Advanced Notice of Proposed Rulemaking, Beneficial Ownership Information Reporting Requirements, 86 Fed. Reg. 17,557 (April. 5, 2021); Notice of Proposed Rulemaking, Beneficial Ownership Information Reporting Requirements, 86 Fed. Reg. 69,920 (Dec. 7, 2021). 19. ANPRM, 86 Fed. Reg. at 69,597. 20. Id.at 69,598. 21. Id. 22. ANPRM, 86 Fed. Reg. at 69,599. 23. Id.
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Directors and Officers Liability Insurance: An Essential Coverage for the Real Estate and Construction Industry By: Craig M. Hirsch In this article, Craig M. Hirsch provides an overview of director and officers liability insurance and the coverage such insurance can provide to participants in the real estate and construction industry. A construction company defends a lawsuit alleging its executives misrepresented the scope of indemnification for building defects throughout work on the project. A real estate developer responds to a homeowner association’s breach of fiduciary duty claim seeking damages and the costs to repair common areas of a mixed-use property. A real estate investment trust (“REIT”)
settles a securities class action filed by a property management firm’s shareholders alleging misleading statements in connection with the REIT’s acquisition of the firm. All these real-world litigation scenarios potentially implicate directors and officers (“D&O”) insurance coverage for underlying losses and financial exposures. Unfortunately, the real estate and construction industry often overlooks D&O policies as an indispensable part of a company’s insurance portfolio to address risks not adequately covered by other lines of coverage. The Five “Ws” of D&O Coverage for Real Estate and Construction Companies Who does it cover? Generally, a D&O policy covers a company and its management for losses arising from third-party claims alleging corporate misconduct in running the business. The scope of coverage is determined by the D&O policy’s terms and conditions read together and the unique definition of key words and phrases within the policy form. The definition of “insured entity” or “named insured” typically includes the policyholder-entity that purchased the D&O policy, as well as its “subsidiaries” over which the policyholder exercises “management control” (i.e., an ownership stake or written agreement to select a majority of the board of directors). Publicly-traded corporations, privatelyheld companies and not-for-profit entities can structure D&O insurance programs with industry-specific wording tailored to their respective risk profiles. D&O policies also cover the company’s directors and officers as “insured persons” and commonly extend coverage to the General Counsel and Director of Risk Management positions. Many D&O policies also cover
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employees, including part-time and seasonal workers, under certain circumstances. Private company D&O policies insure direct “claims” against the policyholder-entity, whereas public company forms typically restrict coverage to “securities claims” alleging wrongdoing in connection with the offer, purchase and sale of securities or violations of securities law. What types of risks, claims and losses trigger coverage? D&O policies have three main insuring agreements or “sides” of coverage for underlying defense costs, settlements and judgments. “Side A” coverage responds to claims against directors and officers (and other individual insureds) resulting in losses not indemnified by the policyholder. “Side B” coverage insures the policyholder against losses incurred by directors and officers that the company is permitted or required to indemnify. “Side C” coverage applies to claims made directly against the policyholder or its subsidiary alleging wrongdoing as an organization. Most D&O coverage grants require the policyholder to satisfy a self-insured retention before the insurer has a duty to defend or indemnify a potentially covered claim. However, Side A coverage for non-indemnifiable losses routinely provides “first dollar” loss protection with no retention, requiring the D&O insurer to defend or pay defense costs immediately with the onset of a claim. D&O policies also include coverage extensions and sublimits for specific operational risks, such as “books and records” demands from shareholders under Section 220 of the Delaware General Corporation Law and requests from regulatory “enforcement units” to interview the company’s management as part of an investigation. Where are risks covered? Most D&O programs have “territory” provisions stating coverage extends to risks anywhere in the world. However, for American companies with international operations, a global D&O program comprised of a US-based “master” policy with interlocking “local” policies placed in certain countries might be necessary. For example, for claims made against insureds in jurisdictions with laws against “non-admitted” insurance policies (i.e., a policy issued by a D&O insurer not licensed to conduct business in the jurisdiction), a US-based D&O policy may be unable to pay claims without the benefit of a locally-underwritten policy form. In addition, some D&O policies include dispute resolution, arbitration or choice of law clauses that determine the forum and insurance law precedents governing coverage disputes or policy interpretation issues. When does the coverage respond? Almost invariably, D&O insurers sell D&O policies on a “claims made” basis, meaning the policies only respond to claims made against insureds during the policy period. This differs from other “occurrence-based” policies, such as commercial general liability insurance, for which the timing of the injury (or injury-causing event) can trigger coverage. D&O policies also include a “cutoff” or retroactive date before which alleged wrongful acts are no longer covered regardless of when the claim originates. Thus, a company’s current D&O insurer might not have a coverage
obligation for a claim made today if it alleges wrongdoing several years ago. Whether coverage is available depends on the negotiated retroactive date and the policy’s language, most notably the “prior events” exclusions barring coverage for claims relating back to earlier misconduct or reporting of matters. Why real estate and construction companies should consider D&O coverage today? If you are a chief financial officer, general counsel or risk manager for a real estate developer, contractor or a private equity firm with property-related assets, D&O insurance can address exposure to management liability claims and pass losses to the D&O insurer. Claims can emerge that commercial general liability or umbrella policies may not address or result in losses traditionally excluded by other liability policy forms. For real estate developers, D&O coverage (and other forms of financial lines protection, such as professional liability insurance) can mitigate risks tied to every facet of a long-term project. For example, the transitional phase between completion of a large-scale residential property and conveyance of title to the homeowners association’s members could create losses covered by D&O programs. If the developer’s employees sit on the homeowners association’s board, alleged breaches of fiduciary duties could trigger the association’s D&O coverage or even the developer’s standalone D&O program, depending on the policy language. Keep in mind that insured “capacity” issues often determine if coverage is available for board service and coverage disputes can swing on whether the developer’s employee committed wrongful acts in his or her role for the association. For contractors and especially privately-held organizations, D&O policies can respond to a wide array of claims brought by shareholders, creditors, vendors and business partners. Even a dispute between a commercial real estate owner and general contractor dispute could produce D&O coverage depending on the wording of the policy’s exclusions and the nature of the claims asserted. One impediment to coverage could be the contractual liability exclusion, found in private company D&O policies, which can bar coverage for claims arising from liability under a “written or oral contract or agreement.” However, many policies include an exception to the exclusion for defense costs and often a director’s or officer’s individual liability remains coverage eligible even if the claim arises from a contractual dispute. For a REIT and other private equity firms with real estate holdings, a robust D&O program is crucial to address a variety of economic and liability risks. Such firms can purchase an “asset protection” or “portfolio management” D&O insurance “tower,” consisting of a primary policy and several layers of excess coverage, offering ample policy limits for securities claims targeting investment funds and their portfolio companies, special purpose entities and even their affiliates. Those asset-based D&O programs usually augment the portfolio company’s D&O coverage pursuant to “other insurance” clauses and the interaction between different policies. Private equity D&O coverage can
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also extend to fund advisers performing investment management services who often become embroiled in shareholder disputes and merger-related litigation as defendants. With respect to real estate investment trusts, economic downturns can impact the projected profitability of commercial property assets and holdings, prompting investor lawsuits against the REIT’s board of directors (including outside directors) alleging breach of fiduciary duty, misrepresentation and negligence. Certain allegations and theories of recovery within those claims could trigger D&O coverage for individual defendants or the trust itself. Final Thoughts for the Real Estate or Construction Company Seeking D&O Coverage The real estate industry should keep in mind several guiding principles when thinking about the placement or renewal of a D&O program or reporting a claim for D&O coverage, including without limitation:
• Consult with experienced insurance recovery counsel: Understanding the strengths and weaknesses of coverage arguments and defenses early in the life of a D&O claim is vital. Real estate and construction companies should always consider working with counsel and experienced brokers to maximize their chances at a significant D&O insurance recovery. ***** Craig Hirsch is a Senior Counsel in the Los Angeles office of Cox, Castle & Nicholson LLP. Mr. Hirsch’s practice focuses on coverage litigation, insurance claim advocacy work and insurance policy analysis on behalf of corporate policyholders, directors and officers.
• The policy language controls: Courts attempt to interpret D&O policies as written and in accordance with the plain meaning of policy wording. In most jurisdictions, coverage grants will be interpreted broadly, while exclusions are narrowly construed and must be drafted in a clear and concise manner. Nevertheless, policyholders should always push for language enhancements to key policy provisions or seek coverage extensions via endorsement during the underwriting process. • Avoid technical coverage defenses: As a policyholder, “good housekeeping” is important to ensure D&O coverage will not be squandered because certain conditions and duties were disregarded, sometimes allowing the D&O insurer to defeat coverage on technical grounds. Make sure you review your D&O policy’s notice and reporting of claims provision, as well as any requirements for insureds to cooperate with their insurers in the defense of underlying claims. In connection with settlement, always be aware of any duty to seek the consent of the insurer before entering into settlement negotiations or extending offers. • Watch out for “hidden” exclusions: In the D&O policy’s exclusion section, the policyholder may find language barring coverage for fraudulent or intentional acts, receiving an illegal profit or financial advantage, or giving “prior notice” of wrongful acts under an earlier policy (among others). However, other areas of the policy form also contain language that can negatively affect coverage. For instance, D&O insurers often point to the “matters uninsurable” clause, typically found in the definition of “loss,” to attempt to deny coverage for damages they characterize as the disgorgement of ill-gotten gains. Thus, it is important to know the ins and outs of the entire D&O policy from the inception of a claim. Take steps to identify limiting clauses buried deep in the policy form’s definitions, conditions and endorsements that the D&O insurer might use to advance coverage defenses. SPRING 2022 24
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Fracas in the French Quarter: Fifth Circuit Weighs in on the Ongoing Controversy Over the Intersection of Bankruptcy Code Sections 363(f) and 365(h) By: David Farrell The Fifth Circuit Court of Appeals joins other Circuits in finding that a bankruptcy sale can be “free and clear” of a tenant’s rights to remain in possession under Section 365(h) of the Bankruptcy Code. The Court’s reasoning on the facts before it are highlighted in this article. Reaching an outcome in line with two other circuit courts, on February 16, 2022, the Fifth Circuit Court of Appeals permitted a Chapter 11 trustee to sell a debtor’s real property free and clear of the leasehold estates held by certain nondebtor lessees. See In re Royal Street Bistro, L.L.C., 2022 WL 499938 (5th Cir. February 16, 2022) (the “Ruling”)
The dispute before the Fifth Circuit arose out of the bankruptcy proceedings of Royal Alice Properties, LLC (the “Debtor”), a single-member limited liability company that filed for Chapter 11 in the United States Bankruptcy Court for the Eastern District of Louisiana (the “Bankruptcy Court”). At the time of its bankruptcy filing, the Debtor held title to three parcels of real property in New Orleans’ famed French Quarter. Before the Chapter 11 filing, the Debtor entered into a series of leases with insiders at below-market rates (collectively, the “Insider Lessees”). The Debtor admitted it filed bankruptcy to prevent a secured lender from foreclosing upon a senior mortgage encumbering all three parcels. After the Debtor lingered in Chapter 11 for over a year without confirming a Chapter 11 plan, the Bankruptcy Court appointed a Chapter 11 trustee. Following his appointment, the Chapter 11 trustee sought approval to sell all three parcels free and clear of any liens and interests, including the interests of the non-debtor lessees. The Chapter 11 trustee relied on Bankruptcy Code Section 363(f )(1), which allows a bankruptcy trustee or debtor-in-possession to sell property of the bankruptcy estate free and clear of third-party “interests” when “applicable non-bankruptcy law permits a sale of such property free and clear of such interests.” 11 U.S.C. §363(f )(1). Background Historically, most lower courts did not allow Chapter 11 debtors and trustees to use Bankruptcy Code Section 363(f ) to sell real property free and clear of leasehold interests over the objections of the non-debtor lessees. These courts reasoned that a sale free and clear of leasehold interests was incompatible with Section 365(h), which generally
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recognizes a lessee’s continued right of possession even after a bankrupt landlord (or its trustee) “rejects” the lease. To these courts, Bankruptcy Code Sections 363(f ) and 365(h)(1) were incompatible with one another, and, since Bankruptcy Code Section 365(h)(1) was more specific, it should control. Then, in 2003, the Seventh Circuit Court of Appeals issued its groundbreaking opinion in Precision Industries, Inc. v. Qualitech Steel, SBQ, LLC (In re Qualitech Steel Corporation), 327 F.3d 537 (7th Cir. 2003)(“Qualitech”). Dismissing the incompatibility argument, the Seventh Circuit held that a Chapter 11 debtorin-possession or trustee may use Bankruptcy Code Section 363(f ) to sell real property free and clear of possessory rights that a non-debtor lessee might otherwise hold under Bankruptcy Code Section 365(h). ZThe Royal Street Bistro case In the Royal Street Bistro case, however, the Insider Lessees timely responded to the Chapter 11 Trustee’s sale motion by filing their own motion seeking both adequate protection under Bankruptcy Code Section 363(e) and requesting the Bankruptcy Court to compel the Chapter 11 trustee to assume or reject the parties’ underlying lease agreements before the sale of the real estate. With respect to their demand for adequate protection, the Insider Lessees insisted that they should be permitted to maintain their possessory rights under Bankruptcy Code Section 365(h) after the sale — a contention for which the Insider Lessees drew support from Dishi & Sons v. Bay Condos LLC, 510 B.R. 696, 711-2 (S.D.N.Y. 2014) (recognizing a non-debtor lessee’s ongoing possessory rights under Bankruptcy Code Section 365(h) as an appropriate form of “adequate protection” in the face of a bankrupt lessor’s proposed “free and clear” sale of the underlying real property). Notwithstanding the Insider Lessees’ careful efforts to evade the fate of the non-debtor lessee parties in Qualitech and Spanish Peaks, the Bankruptcy Court denied their requests for adequate protection and to compel a presale assumption or rejection of their lease agreements. See In re Royal Alice Properties, LLC, 2021 WL 5711988, 9-12 (Bankr. E. D. La. November 30, 2021). Instead, the Bankruptcy Court authorized the Chapter 11 trustee to sell the real property free and clear of the Insider Lessees’ leasehold estates under Bankruptcy Code Section 363(f )(1). Id. The Insider Lessees appealed to the U.S. District Court for the Eastern District of Louisiana (the “District Court”), asking the District Court to stay the Bankruptcy Court’s ruling to prevent the appeal from being rendered statutorily moot under the provisions of Bankruptcy Code Section 363(m). See 11 U.S.C. §363(m)(providing that the reversal on appeal of an order authorizing a sale of property of the bankruptcy estate does not affect the validity of the sale unless the order authorizing the sale is stayed pending appeal). The District Court, however, refused to grant such a stay,
finding (among other things) that the Insider Lessees had failed to demonstrate a likelihood of success on the merits. See In re Royal Street Bistro, LLC, 2022 WL 326636, 5-6 (E.D. La. February 3, 2022). The Insider Lessees then petitioned the Fifth Circuit to issue a writ of mandamus compelling the District Court to stay the effectiveness of the bankruptcy court’s sale order pending the Insider Lessees’ appeal. The appellate decision In what it acknowledged was a less than fully comprehensive discussion of the issues, a three-member panel of the Fifth Circuit (the “Panel”) — which included legendary bankruptcy jurist Judge Edith H. Jones — denied the Insider Lessees’ request for a writ of mandamus in a four-page opinion. See Ruling, at 4. In doing so, the Panel voiced approval with respect to the bulk of the reasoning employed by the Bankruptcy Court. Thus, the Panel agreed with the Bankruptcy Court that the senior mortgagee’s ability to wipe out the Insider Lessees’ leaseholds in a state law foreclosure action not only provided a sufficient basis under Bankruptcy Code Sections 363(f )(1) to allow the real property to be sold free and clear of the Insider Lessees’ leases but it also prevented the Insider Lessees from insisting that their possessory rights be preserved as a form of adequate protection. Id. at 2, n.2 (noting that none of the Insider Lessees’ “leases contained non-disturbance clauses that would have protected the lessees from [a foreclosure by the senior mortgage holder].”). Likewise, the Panel agreed with the Bankruptcy Court’s conclusion that because the underlying property possessed no residual beyond that necessary to satisfy the senior mortgage, the Insider Lessees were not entitled to any other form of “adequate protection.” Id. at 2, n. 3. Notwithstanding its holding, the Panel chastised both the Bankruptcy Court and the District Court for their alleged over-reliance upon the Qualitech opinion. The Panel criticized Qualitech as standing for the “excessively broad proposition that sales free and clear under Section 363 override, and essentially render nugatory, the critical lessee protections against a debtor-lessor under Section 365(h).” Id. at 3. To reinforce the point, the Panel concluded by admonishing “[c] ourts . . . against blithely accepting Qualitech’s reasoning and textual exegesis.” Id. at 4. Conclusions Similar to Qualitech and Spanish Peaks, Royal Street Bistro involved below-market leases whose legitimacy as true leases certainly seemed subject to challenge. Notwithstanding these “bad facts,” the Fifth Circuit’s ruling in Royal Street Bistro represents another Circuit-level decision rejecting the proposition (once widely embraced) that the provisions of
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Bankruptcy Code Section 365(h) should control over those of Bankruptcy Code Section 363(f ). Admittedly, even after the 2003 decision in Qualitech, some courts continued to support the notion that the provisions of Bankruptcy Code Section 365(h) cannot be overcome through a “free and clear” sale under Bankruptcy Code Section 363(f ) See, e.g., In re Revel, AC, Inc., 802 F.3d 558, 575 (3rd Cir. 2015) (wherein the Honorable Thomas L. Ambro, writing for a divided panel of the Third Circuit, stayed a free and clear sale of the debtor’s real property assets so as to allow a non-debtor lessee to pursue on appeal the contention that its rights under Bankruptcy Code Section 365(h) could not be wiped out under Bankruptcy Code Section 363(f )); Dishi & Sons v. Bay Condos LLC, 510 B.R. 696, 708-710 (S.D.N.Y. 2014)(holding that Bankruptcy Code Section 363(f )(1) only pertains to voluntary sales of property by a debtor under applicable state law and, thus, does not authorize a Chapter 11 debtor to sell real property free and clear of a non-debtor lessee’s possessory rights under Bankruptcy Code Section 365(h) on the premise that the lessee’s interests would be wiped-out in a state law foreclosure action).
popular perception that the only reason that the lessees lost in Qualitech and Spanish Peaks was because they did not timely invoke other available remedies and protections, such as demanding “adequate protection” under Bankruptcy Code Section 363(e).
Endnotes 1. David Farrell represents secured lenders, securitization partici-pants, unsecured trade creditors, creditors’ committees, and buyers and sellers of distressed businesses. For more information on the author, click on the hyperlinked author name or the following link: David Farrell | St. Louis, | Thompson Coburn LLP
With three Circuit courts now squarely holding to contrary, it remains to be seen whether courts such as the Third Circuit in Revel and the Southern District of New York in Dishi will continue to adhere to the above-referenced positions. As noted, the Fifth Circuit pushed back rather harshly against what it perceived as Qualitech’s overly broad and facile conclusion that the provisions of Bankruptcy Code Section 363(f ) necessarily override those of Bankruptcy Code 365(h). Nevertheless, the decision in Royal Street Bistro seems to delineate a narrow set of circumstances under which the foregoing outcome will not hold. Indeed, carried to its logical conclusion, the Fifth Circuit’s reasoning in Royal Street Bistro suggests that in those instances in which a debtor’s real property is encumbered by a mortgage (which is almost always the case), a non-debtor lessee confronted by a proposed “free and clear” sale of such real property will not be able to successfully demand that its possessory rights in the property be preserved under Bankruptcy Code Section 365(h) unless either: (a) the lessee’s lease is senior to the mortgage such that the mortgagee would not wipe-out the lessee’s leasehold estate in a state law mortgage foreclosure action; or (b) the lessee and the mortgagee are parties to a pre-petition subordination and non-disturbance agreement that protects the lessee’s leasehold estate from being wiped-out by the mortgagee. By recognizing the foregoing limitations on when a nondebtor lessee’s possessory rights under Bankruptcy Code Section 365(h) will prevail in the face of a “free and clear” sale, the Royal Street Bistro opinion seems to dispel the
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Rethinking Force Majeure Clauses in Commercial Leases in Response to COVID-19 By: Daniel Q. Orvin This article discusses broadening the definition of force majeure in commercial real property leases. What is a Force Majeure Clause? Force majeure is defined in Merriam-Webster Dictionary an “event or effect that cannot be reasonably anticipated or controlled.” In the context of a commercial lease, a force majeure clause excuses the performance of an obligation by a party when that party is prevented or delayed from performing its obligation due to unforeseeable events outside its reasonable control, but the failure to make monetary payments is not generally not excused. Typically, a force majeure clause in a commercial lease includes several events including “acts of God” defined by Merriam-Webster as the “extraordinary interruption by a natural cause (such as a flood
or earthquake) of the usual course of events that experience, prescience, or care cannot reasonably foresee or prevent.” Fallout from COVID-19. The COVID-19 panedmic resulted in global supply chain issues, work force scarcity and the downturn in certain industries (e.g., food and beverage, hospitality, brick and mortar retail, etc.), and many tenants and landlords found it either impossible or impractical to perform certain obligations under their leases. For example, landlords had trouble completing the upfit and tenant improvements for their lessees and delivering improved lease spaces on time with material and labor shortages, and tenants grappled with reduced business income related to government-mandated COVID-19 shutdowns, inventory shortages, and the lack of a sufficient workforce. While most commercial leases included a force majeure clause prior to the onset of COVID-19, many clauses did not specifically address a pandemic or the outbreak of virus or disease as a force majeure event. Nonetheless, tenants and landlords in several jurisdictions brought actions arguing that government intervention, including mandated business shutdowns or quarantines, qualified as force majeure events. Pre-Pandemic Force Majeure Clauses. The following is an example of a typical force majeure clause found in commercial leases without specific pandemic or epidemic language:
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“Unless otherwise specifically provided, in the event that either party hereto shall be delayed or hindered in or prevented from the performance of any act required hereunder by reason of strikes, lock-outs, labor troubles, Act of God, inability to procure materials, failure of power, restrictive governmental laws or regulations, riots, insurrection, war or other reason of a like nature not the fault of the party delayed in performing work or doing acts required under the terms of this Lease (each being referred to herein as “Force Majeure”), then performance of such act shall be excused for period of delay and the period for the performance of any such act shall be extended for a period equivalent to the period of such delay, provided that this subsection will not excuse or delay the payment of money by either party.” Force Majeure Clauses in reaction to COVID-19. After the onset of COVID-19, tenants and landlords were forced to rethink what events qualified as force majeure under the lease. To remove any doubt, force majeure clauses were drafted to include specific references to pandemics, epidemics and other events resulting from a health crisis. Further, these clauses have become more robust generally in reaction to the failure of pre-pandemic force majeure clauses to adequately address the disruption to performance under leases by COVID-19. In addition to addressing pandemicrelated events, force majeure clauses are now being drafted to encompass a wide array of unpredictable events (see example clause below). “If Tenant or Landlord is delayed or prevented from performing any of their respective non-monetary obligations under this Lease, and such delay is by reason of strike, lockout, labor troubles, material shortages, adjustment of any insurance claim, failure of power, riots, civil commotion, insurrection, war (whether declared or undeclared), warlike operations, acts of terrorism, cyber-attacks, acts of public enemy, acts of bioterrorism, plagues, epidemics, pandemics, outbreak of a communicable disease leading to extraordinary restrictions including quarantine or movement of people or goods, invasion, rebellion, hostilities, military or usurped power, sabotage, government action, rain and other inclement weather, acts of God, power outages, inability to obtain any material, utility, or service because of governmental restrictions, inability to obtain building permits, hurricanes, floods, earthquakes, tornadoes, or other natural disasters, accident, emergency, mechanical breakdown, municipal delays (including delays in reviewing materials submitted by a party or issuing permits or approvals following such submittals), the act or failure to act of the other party, the default under this Lease by the other party, governmental preemption in connection with a national emergency, any rule, order or regulation of any department or subdivision of any government agency, or any other cause reasonably beyond such party’s control (where lack of funds, inability to obtain financing, and/or changes in economic condition shall not be a basis for delay or prevention of any obligation under this Lease) (any such event, a “Force
Majeure”), then performance of such act shall be excused for the period of the delay or prevention, and the period of such delay or prevention shall be deemed added to the time period herein provided for the performance of any such obligation by the party so delayed or prevented, provided that this subsection will not excuse or delay the payment of money by either party.” The underlined language above primarily captures pandemicrelated events, but the reference to “material shortages” or “government action” also included in the clause could similarly apply in the pandemic context. Conclusion. The COVID-19 pandemic has shown that landlords and tenants should “expect the unexpected” when it comes to events beyond each party’s control. Therefore, landlords and tenants should strongly consider including a broadly drafted force majeure clause in their commercial leases that includes language addressing pandemics and a comprehensive list of other possible occurrences. The parties should also carefully review how these clauses impact their respective performance under the lease.
Dan is an attorney with Womble Bond Dickinson (US) LLP. Dan’s practice includes commercial transactions, real estate development and real estate and business litigation. With extensive experience developing commercial, industrial and mixed-use properties, handling zoning matters, drafting and negotiating commercial leases and guiding companies in the acquisition, development and sale of apartment and multifamily portfolios, he represents clients in the development and establishment of condominium regimes and other common interest ownership developments. Dan leads a team of attorneys in multiple states and has litigated numerous cases in state and federal court. He has also acted as outside counsel for several title insurance companies. Additionally, he has represented developers, lenders and loan servicers in complex business litigation matters. Dan is a member of the American Bar Association’s Real Property, Trust and Estate Law Section, and a fellow in the American College of Real Estate Lawyers (ACREL) and the American College of Mortgage Attorneys (ACMA). He is also recognized by Best Lawyers in America for real estate as is a South Carolina Super Lawyer in Real Estate.
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Can We Save Time by Using a Negotiated Document from Another Deal? By: Joshua Stein1 This article discusses the efficiency of using negotiated documents from a prior deal. Commercial real estate negotiations often involve lots of drafts of complex documents. Those drafts generate lots of comments in response. Each iteration takes lots of time and effort, or at least often feels that way. Clients become impatient with the process. Perhaps counterintuitively, so do their lawyers. The lawyers know that spending too much time on a transaction can lead to billing complaints – i.e., retroactively working for free on this matter when other clients would probably have been willing to pay to work on other matters. In the worst case, spending too much legal time on endless negotiations can lead to lost clients. In any case it probably won’t produce a huge financial windfall. There must be a better way. Maybe there is. For example, if two parties, such as a national owner of shopping malls and a
chain store, conclude a series of similar transactions (leases) together, they can short-circuit much of the negotiation process by agreeing on a standard form for all their locations. They can tailor that document a bit for specific locations as needed. For a pending ground lease development transaction, we tried a similar approach. Here, we represent the tenant. We previously represented the landlord in a similar transaction, with the same opposing counsel, who had represented the tenant in the earlier transaction. To try to simplify negotiations this time around, lawyers and clients all agreed to use the fully negotiated lease from the earlier deal, minus identifying details and economics, as the starting point for the new deal. Did it work? Mostly. Both sides spared themselves some generic lease negotiations, like fine-tuning the tenant’s maintenance obligations and insurance requirements. The parties had jousted a bit on some of those issues in the earlier transaction, and the resulting document reflected a reasonable outcome in each case. Today’s landlord and tenant didn’t need to reopen any of those conversations. And no one spent any time sprinkling words like “reasonable” and “material” throughout the document, this beautification having already been accomplished. We ran into trouble in other areas. Although both transactions involved ground leases for development, each had its share of deal-specific nuances. Once you have a few of those in any deal, they tend to ripple through the documents.
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It’s easy to identify and remove most deal-specific elements. But where do the deal-specific elements end and the generic elements begin? For example, the earlier deal involved a relatively small, inexperienced, and untested developer. The landlord, our client in that earlier deal, was justifiably concerned about the developer’s credit and competence. Seeking assurance that the developer would finish and pay for the job, the landlord imposed a long list of conditions the developer had to meet before breaking ground. In the more recent deal, on the other hand, the developer (our client) had stronger financial backing and better experience. So, as the developer’s counsel, we sought to remove many of the conditions we had insisted upon when we represented the landlord in the previous deal. The counsel to today’s landlord accused us of inconsistency. We argued that the strength of the developer was a dealspecific difference that justified deviating from the earlier document.
We did that, of course, on the second ground lease deal mentioned above. And now we’re nearly done with negotiations. Although we encountered a few bumps in the road, we have had remarkably little back and forth on generic issues. Instead, we have been able to focus on business issues unique to this transaction.
Endnotes 1. Sole principal, Joshua Stein PLLC (www.joshuastein.com). The author’s three-volume book on ground leases is scheduled for publication in 2023. Mr. Stein has written five previous books and over 300 articles on commercial real estate law and practice, many of which appear on his website. Mr. Stein received his law degree from Columbia Law School, where he was a Harlan Fiske Stone Scholar and a managing editor of the Columbia Law Review. Copyright (c) 2022 Joshua Stein.
In the earlier deal, our landlord client owned billboards near the development site. Our client wanted to preserve the visibility of those billboards. So we wrote detailed provisions into the lease, limiting lighting, signage, and construction that might interfere with the billboards. A generic ground lease would not have included all that specific language. But there it was, thanks to the earlier landlord’s concern about this issue. We tried to delete it for the more recent deal, arguing it was deal-specific and appropriate only for the first deal. As it happened, though, today’s landlord owned other sites nearby and liked the idea of including restrictions to protect views. So today’s tenant/ developer (our client) ended up with stricter view restrictions than might have otherwise applied, because the landlord might not have thought of them. But they’re tolerable. We dodged one potential problem that can arise whenever one uses fully negotiated documents from some other deal: Those earlier documents might contain provisions that were not only deal-specific to the first deal, but potentially lethal if used in the second deal. For example, according to industry lore, in one loan amendment transaction a borrower and lender agreed to clone a previously negotiated mortgage to give the lender liens on a whole series of other properties. The parties did that. The lender missed the fact that the previously negotiated mortgage gave the borrower the right to pay $5 million to obtain a release of the mortgage. That clause made sense in the first deal. But it made no sense at all when the parties used the same mortgage for a series of much more valuable properties. The moral of the story: When using a previously negotiated document, read the whole thing critically from beginning to end.
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The Employee Plans and Executive Compensation Group is a collection of attorneys who focus on a wide range of employee benefits issues. The Group consists of six committees, including: Fiduciary Responsibility, Administration, and Litigation; IRAs & Plan Distributions; Non-Qualified Deferred Compensation; Plan Transactions and Terminations; Qualified Plans; and Welfare Benefit Plans. The goal of the group is to be a valuable source of information and networking for attorneys who practice in this space. The Group has presented on an array of topics including ERISA fee litigation, 457(f) and 403(b) plan updates, employee stock ownership plans, and proposed regulations on required minimum distributions. Our members also participate in CLEs and publish articles related to this practice area, and have opportunities to attend technical sessions with federal agencies such as the IRS, DOL, EEOC and SEC. Join this group to receive notifications of upcoming group meetings and other opportunities to get involved. Trust and Estate Groups and Committees (americanbar.org)
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RESIDENTIAL, MULTI-FAMILY, AND SPECIAL USE GROUP
The Residential, Multi-Family, and Special Use Group addresses issues that pertain to all types of residential properties via its four committees: Affordable Housing, Multi-Family Residential, Senior Housing and Assisted Living, and Single Family Residential. The Affordable Housing Committee focuses on all aspects of the development, acquisition, financing and ownership of affordable housing as well as the governmental programs and policies that support it, including Community Reinvestment Act, LIHTC, PABs, and HUD programs. The Multi-Family Residential committee focuses on all aspects of the development, acquisition, financing, ownership, and sale of multi-family residential property, including FHA, the Americans with Disabilities Act, and HUD programs. The Senior Housing and Assisted Living Committee focuses on the unique issues of providing housing and related services to seniors and encompasses the continuing care retirement community, congregate care assisted living facilities and the residential aspects of nursing care. The SingleFamily Residential Committee focuses on all aspects of the development, acquisition, financing, ownership, and sale of single family residential property, including the impact of FHA, FNMA, FHLMC, VA and HUD programs. Residential, Multi-Family, and Special Use Group members present compelling topics throughout the year via eCLEs, publications, and presentations at the Annual RPTE National CLE Conference. Additionally, the Group members host bi-monthly open conference calls to generate discussion and provide information on trending topics within the aforementioned areas. Join the Residential, Multi-Family, and Special Use Group to receive calendar invitations for bi-monthly calls and other timely communications. If interested in joining please contact the Group Chair, Jennifer Litwak at JLitwak@HousingOnMerit. org or Group Co-Chair, Sarah Cline at scline@MilesStockbridge.com. We look forward to having you join us! Real Property Groups and Committees (americanbar.org)
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Thank you RPTE Section Leadership for your continued support in the development of Section programming, content, publications and for your commitment to Section growth and advancements.
We look forward to celebrating you at the RPTE Fall Leadership Meeting in Anchorage, Alaska.
RPTE LEADING THE DISCUSSION AND ADVANCING THE PROFESSION 2022-2023 Bar Year
September 22-24, 2022. RPTE LEADING THE DISCUSSION AND ADVANCING THE PROFESSION 2022 FALL LEADERSHIP MEETING SEPTEMBER 22-24, 2022 ANCHORAGE, ALASKA
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COMMERCIAL REAL ESTATE TRANSACTIONS GROUP
This group analyzes the transactional and ownership issues which confront commercial real estate attorneys when dealing with land transfers, construction, servitudes, title insurance, property and liability insurance, and ownership of commercial real estate. Each committee within the group focuses on one of these topics. • DESIGN AND CONSTRUCTION • EASEMENTS, RESTRICTIONS AND COVENANTS • GREEN AND SUSTAINABLE TRANSACTIONS • PROPERTY, CASUALTY AND OTHER NON-TITLE INSURANCE • PURCHASE AND SALE • TITLE INSURANCE AND SURVEYS Real Property Groups and Committees (americanbar.org)
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ELDER LAW AND SPECIAL NEEDS PLANNING GROUP
The Elder Law and Special Needs Planning Group consists of two committees that focus on legal concerns of the elderly and persons with disabilities. ELDER LAW AND LONG TERM-CARE The Elder Law and Special Needs Planning Group Committee on Elder Law and Long-Term Care focuses on the legal concerns of the elderly and issues related to long-term care. Committee chairs and committee members are frequently asked to advise the Section leadership on policy positions to be adopted by the ABA House of Delegates. The Committees have been active in presenting CLE programs and in authoring articles for Probate & Property and the Real Property, Trust and Estate Journal. Interested committee members have numerous opportunities to participate in projects and to present their own ideas for projects. We invite you to meet the chairs, check out the webpages for the two committees, and use the numerous links provided. We encourage your participation in committee activities and hope you will join one or all of them. SPECIAL NEEDS PLANNING The Special Needs Planning committee focuses on legal and future planning for individuals with disabilities and their families.
Trust and Estate Groups and Committees (americanbar.org)
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COMMITTEE CONFERENCE CALLS JOINT LAW PRACTICE MANAGEMENT GROUP June 7, 11am CT Join Zoom Meeting https://americanbar.zoom. us/j/94779074134?pwd=S0NmVVBXU1QxMzM2bFFEMXVGL0VyZz09 Meeting ID: 947 7907 4134 Passcode: 189602 877 853 5257 US Toll-free 888 475 4499 US Toll-free SPECIAL INVESTORS AND INVESTMENT STRUCTURE GROUP Real Estate Investment Trusts Committee June 9, 11am CT A Primer on REITs Program Topic: Joe Perrone of PwC will provide a high-level refresher on real estate investment trusts in the U.S. today – what they are, who uses them, why and what ongoing requirements they’re subject to. This webinar will be a great opportunity to become familiar with this tax-advantaged structure or to get a refresher on everything a real estate practitioner should know. Join Zoom Meeting https://americanbar.zoom. us/j/98804511817?pwd=b2hRbit4bE8wYjRUUUNUSzZ6cHJpdz09 Meeting ID: 988 0451 1817 Passcode: 152751 888 475 4499 US Toll-free 877 853 5257 US Toll-free LAND USE ENVIRONMENTAL GROUP June 9, 2pm CT Condemnation Join Zoom Meeting https://americanbar.zoom. us/j/93405090483?pwd=dXdXa1p2REw2NmlmWGtSeTAraDIvUT09 Meeting ID: 934 0509 0483 Passcode: 248853 888 475 4499 US Toll-free 877 853 5257 US Toll-free
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FELLOWS
The ABA Section of Real Property, Trust and Estate Law Fellows Program encourages the active involvement and participation of young lawyers in Section activities. The goal of the program is to give young lawyers an opportunity to become involved in the substantive work of the RPTE Section while developing into future leaders. Each RPTE Fellow is assigned to work with a substantive committee chair, who serves as a mentor and helps expose the Fellow to all aspects of committee membership. Fellows get involved in substantive projects, which can include writing for an RPTE publication, becoming Section liaisons to the ABA Young Lawyers Division or local bar associations, becoming active members of the Membership Committee, and attending important Section leadership meetings. Applications due June 10, 2022. https://www.americanbar.org/groups/ real_property_trust_estate/fellowships-and-awards/fellows/
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A Practical Guide to Commercial Real Estate Transactions: From Contract to Closing, Third Edition By Gregory M Stein, Morton P Fisher Jr, and Michael D Goodwin
$169 NON-MEMBERS $134 YOUR PRICE
Understand how to effectively handle a commercial real estate deal. Useful for attorneys with all levels of experience, the authors explain every aspect of a real estate transaction, focusing on the drafting, negotiation, and revision needed to get the deal done. Includes forms and appendices.
https://ambar.org/practicalguiderpte
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Disclaimers in Estate Planning, Second Edition By Christopher P Cline
$139 NON-MEMBERS $109 YOUR PRICE
Disclaimers are governed by both state and federal law. This concise guide explains the Uniform Acts involved and the specific issues raised by Section 2518 in order to create the best strategies and techniques for effectively utilizing disclaimers.
https://ambar.org/disclaimersrpte SPRING 2022 41
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Learn about Section of Real Property, Trust and Estate Law’s eReport The eReport is the quarterly electronic publication of the American Bar Association Real Property, Trust and Estate Law Section. It includes practical information for lawyers working in the real property and estate planning fields, together with news on Section activities and upcoming events. The eReport also provides resources for seasoned and young lawyers and law students to succeed in the practice of law. For further information on the eReport or to submit an article for publication, please contact Robert Steele(Editor), Cheryl Kelly (Real Property Editor), Raymond Prather (Trust and Estate Editor), or RPTE staff members Bryan Lambert or Monica Larys. Are you interested in reading FAQs on how to get published in the eReport? Download the FAQs here. We welcome your suggestions and submissions! FREQUENTLY ASKED QUESTIONS BY PROSPECTIVE AUTHORS RTPE eReport What makes eReport different from the other Section publications? The most important distinction is that eReport is electronic. It is delivered by email only (see below) and consists of links to electronic versions of articles and other items of interest. Since eReport is electronic, it is flexible in many ways. How is eReport delivered and to whom? eReport is delivered quarterly via email to all Section members with valid email addresses. At the ABA website, www.americanbar.org, click myABA and then navigate to Email, Lists and Subscriptions. You have the option of receiving eReport. Currently almost 17,000 Section members receive eReport. What kind of articles are you looking for? We are looking for timely articles on almost any topic of interest to real estate or trust and estate lawyers. This covers anything from recent case decisions, whether federal or state, if of general interest, administrative rulings, statutory changes, new techniques with practical tips, etc. How long should my article be? Since eReport is electronic and therefore very flexible, we can publish a two page case or ruling summary, and we can publish a 150 page article. eReport is able to do this since the main page consists of links to the underlying article, therefore imposing no page restraints. This is a unique feature of eReport.
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How do I submit an article for consideration? Email either a paragraph on a potential topic or a polished draft – the choice is yours – to the Editor, Robert Steele, at rsteele@ssrga.com, and either our Real Estate Editor, Cheryl Kelly, at ckelly@thompsoncoburn.com, or our Trust and Estate Editor, Raymond Prather, at ray@pratherebner.com. Do I need to have my topic pre-approved before I write my submission? Not required, but the choice is yours. We welcome topic suggestions and can give guidance at that stage, or you may submit a detailed outline or even a full draft. You may even submit an article previously published (discussed below) for our consideration. Do citations need to be in formal Bluebook style? eReport is the most informal publication of the Section. We do not publish with heavy footnotes and all references are in endnotes. If there are citations, however, whether to the case you are writing about, or in endnotes, they should be in proper Bluebook format to allow the reader to find the material. Certainly you may include hyperlinks to materials as well. Can I revise my article after it is accepted for publication? While we do not encourage last minute changes, it is possible to make changes since we work on Word documents until right before publication when all articles are converted to pdf format for publication. What is your editing process? Our Editor and either the Trust and Estate Editor or the Real Estate Editor work together to finalize your article. The article and the style are yours, however, and you are solely responsible for the content and accuracy. We will just help to polish the article, not re-write it. Our authors have a huge variety of styles and we embrace all variety in our publication. Do I get to provide feedback on any changes that you make to my article? Yes. We will email a final draft to you unless we have only made very minor typographical or grammatical changes. Will you accept an article for publication if I previously published it elsewhere? YES! This is another unique feature of eReport. We bring almost 17,000 new readers to your material. Therefore, something substantive published on your firm’s or company’s website or elsewhere may be accepted for publication if we believe that our readers will benefit from your analysis and insight. In some cases, articles are updated or refreshed for eReport. In other cases, we re-publish essentially unchanged, but logos and biographical information is either eliminated or moved to the end of the article. How quickly can you publish my article? Since we publish quarterly, the lead time is rarely more than two months. If you have a submission on a very timely topic, we can publish in under a month and present your insights on a new topic in a matter of weeks.
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