When a business mortgage lending institution sets out to enforce a mortgage loan following a borrower default, a key objective is to recognize the most expeditious way in which the loan provider can obtain control and ownership of the underlying collateral. Under the right set of circumstances, a deed in lieu of foreclosure can be a much faster and more affordable option to the long and drawn-out foreclosure procedure. This post goes over actions and issues lenders should think about when deciding to proceed with a deed in lieu of foreclosure and how to avoid unanticipated dangers and challenges during and following the deed-in-lieu process.
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Consideration

A crucial element of any agreement is ensuring there is appropriate factor to consider. In a standard transaction, consideration can easily be established through the purchase rate, however in a deed-in-lieu situation, validating appropriate consideration is not as straightforward.

In a deed-in-lieu situation, the quantity of the underlying debt that is being forgiven by the lending institution usually is the basis for the factor to consider, and in order for such factor to consider to be considered "appropriate," the financial obligation ought to a minimum of equivalent or exceed the fair market price of the subject residential or commercial property. It is essential that lending institutions acquire an independent third-party appraisal to validate the worth of the residential or commercial property in relation to the amount of debt being forgiven. In addition, its suggested the deed-in-lieu arrangement include the borrower's reveal acknowledgement of the reasonable market price of the residential or commercial property in relation to the quantity of the financial obligation and a waiver of any prospective claims related to the adequacy of the consideration.

Clogging and Recharacterization Issues

Clogging is shorthand for a principal rooted in ancient English common law that a debtor who protects a loan with a mortgage on realty holds an unqualified right to redeem that residential or commercial property from the lending institution by paying back the debt up till the point when the right of redemption is legally snuffed out through a correct foreclosure. Preserving the debtor's fair right of redemption is the reason that, prior to default, mortgage loans can not be structured to contemplate the voluntary transfer of the residential or commercial property to the lending institution.

Deed-in-lieu deals preclude a customer's fair right of redemption, however, actions can be required to structure them to restrict or prevent the danger of an obstructing difficulty. Firstly, the contemplation of the transfer of the residential or commercial property in lieu of a foreclosure need to occur post-default and can not be considered by the underlying loan documents. Parties must likewise watch out for a deed-in-lieu arrangement where, following the transfer, there is a continuation of a debtor/creditor relationship, or which contemplate that the debtor maintains rights to the residential or commercial property, either as a residential or commercial property manager, a tenant or through repurchase choices, as any of these arrangements can create a threat of the deal being recharacterized as a fair mortgage.

Steps can be taken to mitigate against recharacterization risks. Some examples: if a customer's residential or commercial property management functions are restricted to ministerial functions rather than substantive choice making, if a lease-back is brief term and the payments are plainly structured as market-rate use and occupancy payments, or if any arrangement for reacquisition of the residential or commercial property by the customer is set up to be entirely independent of the condition for the deed in lieu.

While not determinative, it is suggested that deed-in-lieu arrangements consist of the celebrations' clear and indisputable recognition that the transfer of the residential or commercial property is an outright conveyance and not a transfer of for security purposes just.

Merger of Title

When a lending institution makes a loan protected by a mortgage on property, it holds an interest in the real estate by virtue of being the mortgagee under a mortgage (or a recipient under a deed of trust). If the lending institution then obtains the property from a defaulting mortgagor, it now also 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 general rule on this issue offers 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 proof of a contrary intention. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is very important the arrangement plainly reflects the parties' intent to keep the mortgage lien estate as distinct from the fee so the lender maintains the capability to foreclose the underlying mortgage if there are stepping in liens. If the estates combine, then the lending institution's mortgage lien is snuffed out and the loan provider loses the capability to deal with stepping in liens by foreclosure, which could leave the lending institution in a potentially even worse position than if the lender pursued a foreclosure from the outset.

In order to plainly reflect the parties' intent on this point, the deed-in-lieu contract (and the deed itself) must include express anti-merger language. Moreover, since there can be no mortgage without a debt, it is traditional in a deed-in-lieu situation for the lending institution to deliver a covenant not to take legal action against, instead of a straight-forward release of the financial obligation. The covenant not to sue furnishes consideration for the deed in lieu, secures the borrower versus exposure from the financial obligation and also keeps the lien of the mortgage, thereby enabling the lender to preserve the ability to foreclose, needs to it end up being desirable to remove junior encumbrances after the deed in lieu is total.

Transfer Tax

Depending on the jurisdiction, handling transfer tax and the payment thereof in deed-in-lieu deals can be a considerable sticking point. While many states make the payment of transfer tax a seller commitment, as a practical matter, the loan provider ends up taking in the cost given that the borrower is in a default scenario and generally lacks funds.

How transfer tax is calculated on a deed-in-lieu transaction depends on the jurisdiction and can be a driving force in figuring out if a deed in lieu is a viable 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 as much as the quantity of the financial obligation. Some other states, including Washington and Illinois, have simple exemptions for deed-in-lieu transactions. In Connecticut, however, while there is an exemption for deed-in-lieu deals it is restricted just to a transfer of the debtor's personal residence.

For a commercial deal, the tax will be calculated based on the full purchase price, which is expressly specified as including the amount of liability which is presumed or to which the real estate is subject. Similarly, but a lot more possibly severe, New York bases the quantity of the transfer tax on "factor to consider," which is specified as the unpaid balance of the debt, plus the total quantity of any other surviving liens and any quantities paid by the beneficiary (although if the loan is fully option, the factor to consider is capped at the reasonable market price of the residential or commercial property plus other amounts paid). Bearing in mind the loan provider will, in a lot of jurisdictions, need to pay this tax again when eventually selling 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 significant concern for loan providers when figuring out if a deed in lieu is a practical option is the concern that if the borrower becomes a debtor in an insolvency case after the deed in lieu is total, the insolvency court can cause the transfer to be unwound or set aside. Because a deed-in-lieu transaction is a transfer made on, or account of, an antecedent financial obligation, it falls directly within subsection (b)( 2) of Section 547 of the Bankruptcy Code dealing with preferential transfers. Accordingly, if the transfer was made when the borrower was insolvent (or the transfer rendered the debtor insolvent) and within the 90-day duration set forth in the Bankruptcy Code, the customer ends up being a debtor in a personal bankruptcy case, then the deed in lieu is at threat of being reserved.

Similarly, under Section 548 of the Bankruptcy Code, a transfer can be reserved if it is made within one year prior to a bankruptcy filing and the transfer was made for "less than a fairly equivalent worth" and if the transferor was insolvent at the time of the transfer, ended up being insolvent since of the transfer, was engaged in an organization that preserved an unreasonably low level of capital or meant to incur debts beyond its capability to pay. In order to reduce against these risks, a loan provider needs to thoroughly examine and examine the debtor's financial condition and liabilities and, preferably, require audited monetary declarations to confirm the solvency status of the debtor. Moreover, the deed-in-lieu arrangement needs to include representations regarding solvency and a covenant from the customer not to apply for personal bankruptcy during the preference duration.

This is yet another reason it is necessary for a loan provider to procure an appraisal to verify the worth of the residential or commercial property in relation to the debt. An existing appraisal will help the loan provider refute any allegations that the transfer was made for less than reasonably comparable value.

Title Insurance

As part of the initial acquisition of a real residential or commercial property, the majority of owners and their lenders will get policies of title insurance to safeguard 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 count on its lending institution's policy when it ends up being the fee owner. Coverage under a lender's policy of title insurance can continue after the acquisition of title if title is taken by the same entity that is the called guaranteed under the lender's policy.

Since many loan providers choose to have actually title vested in a separate affiliate entity, in order to guarantee ongoing coverage under the lender's policy, the named loan provider should assign the mortgage to the designated affiliate title holder prior to, or simultaneously with, the transfer of the cost. In the option, the loan provider 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 business or a completely owned subsidiary (although in some jurisdictions this could activate transfer tax liability).

Notwithstanding the extension in coverage, a lending institution's policy does not convert to an owner's policy. Once the lending institution ends up being an owner, the nature and scope of the claims that would be made under a policy are such that the would not supply the exact same or an adequate level of security. Moreover, a loan provider's policy does not get any protection for matters which develop after the date of the mortgage loan, leaving the loan provider exposed to any problems or claims originating from occasions which take place after the initial closing.

Due to the reality deed-in-lieu transactions are more susceptible to challenge and dangers as described above, any title insurance company issuing an owner's policy is most likely to undertake a more rigorous review of the deal throughout the underwriting process than they would in a normal third-party purchase and sale transaction. The title insurer will scrutinize the parties and the deed-in-lieu documents in order to determine and mitigate dangers presented by concerns such as merger, blocking, recharacterization and insolvency, consequently potentially increasing the time and expenses included in closing the transaction, however ultimately supplying the loan provider with a higher level of protection than the loan provider would have missing the title business's participation.

Ultimately, whether a deed-in-lieu transaction is a practical alternative for a lender is driven by the particular realities and situations of not only the loan and the residential or commercial property, but the parties included as well. Under the right set of situations, therefore long as the correct due diligence and documentation is obtained, a deed in lieu can provide the loan provider with a more effective and less pricey means to realize on its collateral when a loan goes into default.

Harris Beach Murtha's Commercial Property 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 lawyer with whom you most often work.
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