When a business mortgage loan provider sets out to enforce a mortgage loan following a customer default, an essential objective is to identify the most expeditious manner in which the lender can obtain control and ownership of the underlying collateral. Under the right set of situations, a deed in lieu of foreclosure can be a quicker and more affordable option to the long and drawn-out foreclosure procedure. This post discusses steps and concerns lending institutions must think about when deciding to continue with a deed in lieu of foreclosure and how to prevent unforeseen risks and during and following the deed-in-lieu procedure.
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Consideration

A crucial element of any agreement is making sure there is adequate factor to consider. In a basic deal, factor to consider can easily be developed through the purchase price, however in a deed-in-lieu scenario, verifying adequate consideration is not as straightforward.

In a deed-in-lieu scenario, the amount of the underlying financial obligation 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 deemed "appropriate," the financial obligation needs to a minimum of equal or go beyond the reasonable market price of the subject residential or commercial property. It is crucial that lenders get an independent third-party appraisal to validate the worth of the residential or commercial property in relation to the quantity of debt being forgiven. In addition, its recommended the deed-in-lieu agreement consist of the debtor's reveal acknowledgement of the reasonable market value of the residential or commercial property in relation to the quantity of the debt and a waiver of any possible claims associated with the adequacy of the consideration.
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Clogging and Recharacterization Issues

Clogging is shorthand for a primary rooted in ancient English common law that a borrower who secures a loan with a mortgage on genuine estate holds an unqualified right to redeem that residential or commercial property from the loan provider by paying back the financial obligation up until the point when the right of redemption is legally extinguished through a proper foreclosure. Preserving the borrower's equitable right of redemption is the reason, prior to default, mortgage loans can not be structured to contemplate the voluntary transfer of the residential or commercial property to the lender.

Deed-in-lieu deals preclude a borrower's fair right of redemption, however, actions can be taken to structure them to limit or prevent the threat of a clogging challenge. Firstly, the reflection of the transfer of the residential or commercial property in lieu of a foreclosure must happen post-default and can not be pondered by the underlying loan files. 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 ponder that the debtor maintains rights to the residential or commercial property, either as a residential or commercial property supervisor, a renter or through repurchase options, as any of these arrangements can develop a risk of the deal being recharacterized as a fair mortgage.

Steps can be taken to mitigate versus recharacterization dangers. 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 brief term and the payments are plainly structured as market-rate usage and tenancy payments, or if any arrangement for reacquisition of the residential or commercial property by the debtor is established to be completely independent of the condition for the deed in lieu.

While not determinative, it is recommended that deed-in-lieu agreements consist of 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 realty, 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 gets 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 getting the mortgagor's equity of redemption.

The basic guideline on this issue supplies that, where a mortgagee gets the charge or equity of redemption in the mortgaged residential or commercial property, and there is no intermediate estate, merger of the mortgage interest into the charge takes place in the absence of proof of a contrary objective. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is very important the arrangement clearly shows the celebrations' intent to retain the mortgage lien estate as unique from the fee so the lender keeps the ability to foreclose the hidden mortgage if there are stepping in liens. If the estates combine, then the loan provider's mortgage lien is snuffed out and the lending institution loses the capability to deal with stepping in liens by foreclosure, which might leave the lender in a potentially worse position than if the lending institution pursued a foreclosure from the outset.

In order to plainly show the celebrations' intent on this point, the deed-in-lieu contract (and the deed itself) need to include reveal anti-merger language. Moreover, because there can be no mortgage without a financial obligation, it is customary in a deed-in-lieu scenario for the lending institution to provide a covenant not to sue, instead of a straight-forward release of the financial obligation. The covenant not to take legal action against furnishes factor to consider for the deed in lieu, safeguards the customer versus direct exposure from the financial obligation and also keeps the lien of the mortgage, thus allowing the loan provider to preserve the ability to foreclose, ought to it end up being desirable to remove junior encumbrances after the deed in lieu is complete.

Transfer Tax

Depending on the jurisdiction, dealing with 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 obligation, as a practical matter, the lender winds up taking in the expense because the borrower is in a default circumstance and usually does not have funds.

How transfer tax is calculated on a deed-in-lieu deal depends on the jurisdiction and can be a driving force in determining if a deed in lieu is a feasible option. In California, for example, 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 simple exemptions for deed-in-lieu deals. In Connecticut, however, while there is an exemption for deed-in-lieu deals it is limited just to a transfer of the borrower's individual residence.

For a business deal, the tax will be determined based on the full purchase rate, which is specifically defined as consisting of the amount of liability which is presumed or to which the real estate is subject. Similarly, however even more possibly extreme, New york city bases the amount of the transfer tax on "consideration," which is specified as the unpaid balance of the financial obligation, plus the total quantity of any other making it through liens and any amounts paid by the beneficiary (although if the loan is fully recourse, the factor to consider is capped at the reasonable market price of the residential or commercial property plus other quantities paid). Remembering the lender will, in many jurisdictions, need to pay this tax once again when ultimately 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 alternative.

Bankruptcy Issues

A major concern for lenders when figuring out if a deed in lieu is a viable option is the issue that if the borrower becomes a debtor in an insolvency case after the deed in lieu is complete, the insolvency 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 debt, it falls directly within subsection (b)( 2) of Section 547 of the Bankruptcy Code handling preferential transfers. Accordingly, if the transfer was made when the debtor was insolvent (or the transfer rendered the customer insolvent) and within the 90-day period set forth in the Bankruptcy Code, the borrower ends up being a debtor in a bankruptcy case, then the deed in lieu is at risk of being set aside.

Similarly, under Section 548 of the Bankruptcy Code, a transfer can be set aside if it is made within one year prior to a personal bankruptcy filing and the transfer was made for "less than a fairly comparable value" and if the transferor was insolvent at the time of the transfer, became insolvent due to the fact that of the transfer, was engaged in a business that preserved an unreasonably low level of capital or meant to incur debts beyond its ability to pay. In order to mitigate versus these dangers, a lending institution ought to carefully review and examine the borrower's monetary condition and liabilities and, ideally, require audited financial statements to validate the solvency status of the debtor. Moreover, the deed-in-lieu agreement must include representations as to solvency and a covenant from the debtor not to declare insolvency throughout the preference period.

This is yet another reason it is vital for a loan provider to acquire an appraisal to validate the worth of the residential or commercial property in relation to the debt. An existing appraisal will assist the lender refute any allegations that the transfer was produced less than fairly equivalent worth.

Title Insurance

As part of the initial acquisition of a real residential or commercial property, a lot of owners and their loan providers will acquire policies of title insurance coverage to protect their respective interests. A lender thinking about taking title to a residential or commercial property by virtue of a deed in lieu may ask whether it can count on its loan provider's policy when it becomes the fee owner. Coverage under a lender's policy of title insurance coverage can continue after the acquisition of title if title is taken by the same entity that is the named insured under the loan provider's policy.

Since numerous loan providers prefer to have title vested in a different affiliate entity, in order to make sure continued protection under the loan provider's policy, the named loan provider needs to appoint the mortgage to the desired affiliate victor prior to, or all at once with, the transfer of the cost. In the option, the lender can take title and then communicate the residential or commercial property by deed for no consideration to either its moms and dad company or an entirely owned subsidiary (although in some jurisdictions this could trigger transfer tax liability).

Notwithstanding the continuation in protection, a lender's policy does not convert to an owner's policy. Once the lending institution becomes an owner, the nature and scope of the claims that would be made under a policy are such that the loan provider's policy would not provide the exact same or a sufficient level of security. Moreover, a lender's policy does not obtain any defense for matters which develop after the date of the mortgage loan, leaving the lender exposed to any issues or claims coming from events which happen after the original closing.

Due to the reality deed-in-lieu deals are more susceptible to challenge and dangers as described above, any title insurance provider providing 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 deal. The title insurance provider will inspect the parties and the deed-in-lieu documents in order to determine and mitigate risks provided by problems such as merger, blocking, recharacterization and insolvency, thus possibly increasing the time and costs associated with closing the deal, however eventually offering the lender with a greater level of security than the lending institution would have absent the title business's participation.

Ultimately, whether a deed-in-lieu transaction is a viable choice for a lending institution is driven by the particular truths and situations of not just the loan and the residential or commercial property, however the parties involved also. Under the right set of scenarios, and so long as the proper due diligence and documentation is obtained, a deed in lieu can offer the loan provider with a more efficient and cheaper means to realize on its security when a loan goes into default.

Harris Beach Murtha's Commercial Property Practice Group is experienced with deed in lieu of foreclosures. If you require support 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.