When an industrial mortgage loan provider sets out to enforce a mortgage loan following a borrower default, a crucial objective is to identify the most expeditious way in which the lender can obtain control and ownership of the underlying security. Under the right set of scenarios, a deed in lieu of foreclosure can be a much faster and more cost-effective alternative to the long and protracted foreclosure process. This post talks about actions and issues lenders need to consider when deciding to continue with a deed in lieu of foreclosure and how to avoid unforeseen risks and obstacles during and following the deed-in-lieu process.
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Consideration

A key element of any contract is guaranteeing there is appropriate factor to consider. In a basic deal, consideration can easily be developed through the purchase rate, but in a deed-in-lieu situation, confirming sufficient factor to consider is not as uncomplicated.

In a deed-in-lieu situation, the quantity of the underlying financial obligation that is being forgiven by the loan provider normally is the basis for the consideration, and in order for such consideration to be deemed "adequate," the financial obligation needs to a minimum of equivalent or exceed the reasonable market value of the subject residential or commercial property. It is vital that loan providers acquire an independent third-party appraisal to validate the value of the residential or commercial property in relation to the quantity of debt being forgiven. In addition, its advised the deed-in-lieu agreement consist of the customer's express acknowledgement of the fair market price of the residential or commercial property in relation to the quantity of the financial obligation and a waiver of any possible claims connected to the adequacy of the factor to consider.

Clogging and Recharacterization Issues

Clogging is shorthand for a primary rooted in ancient English common law that a customer who secures a loan with a mortgage on realty holds an unqualified right to redeem that residential or commercial property from the loan provider by paying back the debt up till the point when the right of redemption is legally snuffed out through an appropriate foreclosure. Preserving the borrower's equitable right of redemption is the reason that, prior to default, mortgage loans can not be structured to consider the voluntary transfer of the residential or commercial property to the loan provider.

Deed-in-lieu deals preclude a customer's equitable right of redemption, however, actions can be taken to structure them to restrict or avoid the threat of a clogging difficulty. Firstly, the reflection of the transfer of the residential or commercial property in lieu of a foreclosure must take place post-default and can not be contemplated by the underlying loan documents. Parties ought to also watch out for a deed-in-lieu arrangement where, following the transfer, there is a continuation of a debtor/creditor relationship, or which consider that the borrower maintains rights to the residential or commercial property, either as a residential or commercial property manager, a renter or through repurchase alternatives, as any of these arrangements can create a threat of the deal being recharacterized as an equitable mortgage.

Steps can be required to mitigate versus recharacterization threats. Some examples: if a debtor's residential or commercial property management functions are limited to ministerial functions instead of substantive decision making, if a lease-back is short term and the payments are clearly structured as market-rate usage and occupancy payments, or if any provision for reacquisition of the residential or commercial property by the debtor is established to be entirely independent of the condition for the deed in lieu.

While not determinative, it is suggested that deed-in-lieu contracts include the celebrations' clear and unequivocal recognition that the transfer of the residential or commercial property is an absolute conveyance and not a transfer of for security functions only.

Merger of Title

When a lending institution makes a loan secured by a mortgage on genuine estate, it holds an interest in the property by virtue of being the mortgagee under a mortgage (or a recipient under a deed of trust). If the loan provider then acquires the realty from a defaulting mortgagor, it now likewise holds an interest in the residential or commercial property by virtue of being the charge owner and obtaining the mortgagor's equity of redemption.

The basic rule on this problem supplies that, where a mortgagee gets the fee or equity of redemption in the mortgaged residential or commercial property, and there is no intermediate estate, merger of the mortgage interest into the fee takes place in the absence of evidence of a contrary objective. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is essential the agreement plainly shows the celebrations' intent to maintain the mortgage lien estate as distinct from the fee so the lending institution keeps the capability to foreclose the hidden mortgage if there are stepping in liens. If the estates merge, then the lending institution's mortgage lien is extinguished and the lender loses the capability to handle stepping in liens by foreclosure, which could leave the loan provider in a possibly even worse position than if the lender pursued a foreclosure from the beginning.

In order to clearly reflect the parties' intent on this point, the deed-in-lieu arrangement (and the deed itself) must consist of reveal anti-merger language. Moreover, because there can be no mortgage without a financial obligation, it is customary in a deed-in-lieu circumstance for the lender to deliver a covenant not to take legal action against, rather than a straight-forward release of the financial obligation. The covenant not to sue furnishes consideration for the deed in lieu, safeguards the customer against exposure from the debt and also maintains the lien of the mortgage, therefore permitting the lending institution to preserve the capability to foreclose, should it end up being desirable to eliminate junior encumbrances after the deed in lieu is total.

Transfer Tax

Depending upon the jurisdiction, handling transfer tax and the payment thereof in deed-in-lieu transactions can be a substantial sticking point. While most states make the payment of transfer tax a seller commitment, as a useful matter, the lending institution winds up absorbing the cost since the customer remains in a default scenario and typically lacks funds.

How transfer tax is computed on a deed-in-lieu transaction depends on the jurisdiction and can be a driving force in out if a deed in lieu is a feasible alternative. In California, for instance, a conveyance or transfer from the mortgagor to the mortgagee as a result of a foreclosure or a deed in lieu will be exempt up to the amount of the financial obligation. Some other states, including Washington and Illinois, have straightforward exemptions for deed-in-lieu transactions. In Connecticut, however, while there is an exemption for deed-in-lieu deals it is limited only to a transfer of the customer's individual home.

For a business transaction, the tax will be computed based on the full purchase rate, which is specifically specified as consisting of the amount of liability which is assumed or to which the real estate is subject. Similarly, however even more potentially heavy-handed, New york city bases the amount of the transfer tax on "consideration," which is specified as the unsettled balance of the debt, plus the overall amount of any other enduring liens and any amounts paid by the beneficiary (although if the loan is fully option, the consideration is capped at the fair market worth of the residential or commercial property plus other amounts paid). Keeping in mind the loan provider will, in a lot of jurisdictions, have to pay this tax once again when eventually offering the residential or commercial property, the specific jurisdiction's rules on transfer tax can be a determinative consider choosing whether a deed-in-lieu transaction is a feasible option.

Bankruptcy Issues

A major concern for lending institutions when figuring out if a deed in lieu is a viable option is the concern that if the borrower becomes a debtor in an insolvency case after the deed in lieu is total, the personal bankruptcy court can trigger the transfer to be unwound or set aside. Because a deed-in-lieu deal is a transfer made on, or account of, an antecedent financial obligation, it falls squarely within subsection (b)( 2) of Section 547 of the Bankruptcy Code dealing with preferential transfers. Accordingly, if the transfer was made when the debtor was insolvent (or the transfer rendered the debtor insolvent) and within the 90-day duration stated in the Bankruptcy Code, the borrower ends up being a debtor in a bankruptcy case, then the deed in lieu is at danger of being set aside.

Similarly, under Section 548 of the Bankruptcy Code, a transfer can be reserved if it is made within one year prior to an insolvency filing and the transfer was produced "less than a fairly comparable value" and if the transferor was insolvent at the time of the transfer, ended up being insolvent because of the transfer, was taken part in a service that maintained an unreasonably low level of capital or planned to incur financial obligations beyond its capability to pay. In order to mitigate against these dangers, a loan provider needs to carefully examine and assess the borrower's financial condition and liabilities and, preferably, need audited financial declarations to validate the solvency status of the borrower. Moreover, the deed-in-lieu arrangement needs to include representations as to solvency and a covenant from the customer not to submit for personal bankruptcy throughout the preference period.

This is yet another reason it is crucial for a lending institution to obtain an appraisal to verify the value of the residential or commercial property in relation to the financial obligation. An existing appraisal will help the lender refute any accusations that the transfer was made for less than reasonably comparable value.

Title Insurance

As part of the initial acquisition of a genuine residential or commercial property, many owners and their loan providers will get policies of title insurance coverage to secure their respective interests. A lending institution considering taking title to a residential or commercial property by virtue of a deed in lieu might ask whether it can depend on its loan provider's policy when it ends up being the fee owner. Coverage under a lending institution's policy of title insurance coverage can continue after the acquisition of title if title is taken by the same entity that is the called guaranteed under the loan provider's policy.

Since numerous lending institutions prefer to have actually title vested in a separate affiliate entity, in order to make sure continued coverage under the lending institution's policy, the named lender ought to assign the mortgage to the designated affiliate title holder prior to, or at the same time with, the transfer of the cost. In the option, the lender can take title and after that convey the residential or commercial property by deed for no factor to consider to either its moms and dad company or an entirely owned subsidiary (although in some jurisdictions this could trigger transfer tax liability).

Notwithstanding the extension in coverage, a loan provider's policy does not transform to an owner's policy. Once the lender ends up being an owner, the nature and scope of the claims that would be made under a policy are such that the lending institution's policy would not supply the same or an appropriate level of defense. Moreover, a lending institution's policy does not obtain any security for matters which occur after the date of the mortgage loan, leaving the loan provider exposed to any problems or claims originating from events which happen after the initial closing.

Due to the truth deed-in-lieu transactions are more susceptible to challenge and threats as detailed above, any title insurance provider releasing an owner's policy is likely to carry out a more strenuous evaluation of the transaction throughout the underwriting procedure than they would in a typical third-party purchase and sale deal. The title insurance provider will inspect the celebrations and the deed-in-lieu files in order to determine and mitigate dangers presented by concerns such as merger, blocking, recharacterization and insolvency, consequently potentially increasing the time and expenses involved in closing the transaction, however ultimately providing the loan provider with a higher level of security than the lending institution would have absent the title company's involvement.

Ultimately, whether a deed-in-lieu transaction is a feasible option for a lending institution is driven by the specific facts and circumstances of not only the loan and the residential or commercial property, however the parties included too. Under the right set of circumstances, therefore long as the appropriate due diligence and documentation is acquired, a deed in lieu can supply the lender with a more efficient and cheaper means to recognize on its security when a loan enters into default.

Harris Beach Murtha's Commercial Real Estate Practice Group is experienced with deed in lieu of foreclosures. If you need help with such matters, please connect to attorney Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach attorney with whom you most frequently work.
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