When an industrial mortgage loan provider sets out to impose a mortgage loan following a debtor default, an essential goal is to identify the most expeditious manner in which the loan provider can acquire control and ownership of the underlying security. Under the right set of situations, a deed in lieu of foreclosure can be a quicker and more affordable alternative to the long and protracted foreclosure process. This article discusses steps and concerns loan providers need to think about when deciding to proceed with a deed in lieu of foreclosure and how to prevent unexpected dangers and challenges throughout and following the deed-in-lieu process.

Consideration

A crucial element of any contract is ensuring there is appropriate consideration. In a basic transaction, factor to consider can easily be developed through the purchase rate, but in a deed-in-lieu circumstance, validating appropriate factor to consider is not as simple.

In a deed-in-lieu circumstance, the amount of the underlying debt that is being forgiven by the lender normally is the basis for the factor to consider, and in order for such consideration to be deemed "appropriate," the debt needs to at least equal or surpass the fair market worth of the subject residential or commercial property. It is imperative that loan providers obtain an independent third-party appraisal to substantiate the value of the residential or commercial property in relation to the quantity of debt being forgiven. In addition, its recommended the deed-in-lieu contract consist of the debtor's express recognition of the reasonable market worth of the residential or commercial property in relation to the amount of the debt and a waiver of any prospective 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 debtor who protects a loan with a mortgage on real estate holds an unqualified right to redeem that residential or commercial property from the loan provider by paying back the debt up until the point when the right of redemption is lawfully snuffed out through an appropriate foreclosure. Preserving the debtor'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 lending institution.

Deed-in-lieu deals prevent a customer's equitable right of redemption, nevertheless, actions can be required to structure them to restrict or avoid the risk of an obstructing obstacle. Most importantly, the reflection of the transfer of the residential or commercial property in lieu of a foreclosure should occur post-default and can not be contemplated by the underlying loan files. Parties should also be careful of a deed-in-lieu plan where, following the transfer, there is a continuation of a debtor/creditor relationship, or which contemplate that the debtor keeps rights to the residential or commercial property, either as a residential or commercial property supervisor, a tenant or through repurchase alternatives, as any of these plans can produce a risk of the transaction being recharacterized as a fair mortgage.

Steps can be taken to mitigate versus recharacterization dangers. Some examples: if a customer's residential or commercial property management functions are restricted to ministerial functions instead of substantive choice making, if a lease-back is brief term and the payments are plainly structured as market-rate usage and tenancy payments, or if any provision for reacquisition of the residential or commercial property by the customer is set up to be completely independent of the condition for the deed in lieu.

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

Merger of Title

When a lender 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 lending institution then gets the realty from a defaulting mortgagor, it now likewise holds an interest in the residential or commercial property by virtue of being the cost owner and getting the mortgagor's equity of redemption.

The general rule on this issue provides that, where a mortgagee acquires 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 occurs in the absence of evidence of a contrary intent. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is very important the arrangement clearly reflects the parties' intent to retain the mortgage lien estate as distinct from the fee so the lending institution retains the ability to foreclose the underlying mortgage if there are intervening liens. If the estates combine, then the loan provider's mortgage lien is extinguished and the lending institution loses the ability to handle intervening liens by foreclosure, which could leave the lender in a possibly even worse position than if the loan provider pursued a foreclosure from the start.

In order to plainly show the parties' intent on this point, the deed-in-lieu arrangement (and the deed itself) need to include express anti-merger language. Moreover, due to the fact that there can be no mortgage without a debt, it is traditional in a deed-in-lieu circumstance for the lending institution to deliver a covenant not to take legal action against, rather than a straight-forward release of the financial obligation. The covenant not to take legal action against furnishes consideration for the deed in lieu, safeguards the customer versus direct exposure from the debt and also retains the lien of the mortgage, thereby allowing the lender to preserve the capability to foreclose, ought to it become preferable to get rid of 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 the majority of states make the payment of transfer tax a seller responsibility, as a useful matter, the lender ends up absorbing the cost because the debtor remains in a default situation and generally does not have funds.

How transfer tax is determined on a deed-in-lieu transaction is reliant on the jurisdiction and can be a driving force in determining if a deed in lieu is a practical option. In California, for instance, a conveyance or transfer from the mortgagor to the mortgagee as an outcome of a foreclosure or a deed in lieu will be exempt as much as the quantity of the financial obligation. Some other states, consisting of 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 limited just to a transfer of the debtor's individual home.

For a business deal, the tax will be determined based on the full purchase rate, which is specifically defined as including the amount of liability which is assumed or to which the real estate is subject. Similarly, but a lot more potentially exorbitant, New York bases the quantity of the transfer tax on "factor to consider," which is defined as the unsettled balance of the debt, plus the total amount of any other enduring liens and any amounts paid by the grantee (although if the loan is completely recourse, the factor to consider is topped at the reasonable market price of the residential or commercial property plus other amounts paid). Bearing in mind the lender will, in the majority of jurisdictions, need to pay this tax again when ultimately offering the residential or commercial property, the particular jurisdiction's guidelines on transfer tax can be a determinative factor in choosing whether a deed-in-lieu deal is a feasible choice.

Bankruptcy Issues

A major issue for lenders when identifying if a deed in lieu is a feasible option is the issue that if the customer becomes a debtor in an insolvency case after the deed in lieu is total, the insolvency court can trigger the transfer to be unwound or reserved. Because a deed-in-lieu transaction 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 handling preferential transfers. Accordingly, if the transfer was made when the customer was insolvent (or the transfer rendered the customer insolvent) and within the 90-day duration set forth in the Bankruptcy Code, the customer ends up being a debtor in an insolvency 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 reasonably comparable value" and if the transferor was insolvent at the time of the transfer, ended up being insolvent since of the transfer, was participated in an that preserved an unreasonably low level of capital or intended to sustain debts beyond its ability to pay. In order to reduce against these risks, a lending institution needs to thoroughly evaluate and assess the customer's financial condition and liabilities and, ideally, need audited financial statements to confirm the solvency status of the debtor. Moreover, the deed-in-lieu arrangement ought to consist of representations regarding solvency and a covenant from the borrower not to file for insolvency throughout the choice duration.

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

Title Insurance

As part of the preliminary acquisition of a real residential or commercial property, most owners and their lending institutions will acquire policies of title insurance to secure their respective interests. A lender thinking about taking title to a residential or commercial property by virtue of a deed in lieu might ask whether it can rely on its lending institution's policy when it becomes the cost owner. Coverage under a loan provider's policy of title insurance can continue after the acquisition of title if title is taken by the same entity that is the called insured under the lending institution's policy.

Since numerous lending institutions prefer to have title vested in a separate affiliate entity, in order to guarantee continued protection under the lending institution's policy, the called lending institution needs to appoint the mortgage to the desired affiliate title holder prior to, or concurrently with, the transfer of the charge. In the alternative, the lender can take title and then communicate the residential or commercial property by deed for no factor to consider to either its parent business or a completely owned subsidiary (although in some jurisdictions this might trigger transfer tax liability).

Notwithstanding the continuation in coverage, a loan provider's policy does not convert to an owner's policy. Once the loan provider 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 supply the very same or a sufficient level of protection. Moreover, a loan provider's policy does not obtain any security for matters which arise after the date of the mortgage loan, leaving the loan provider exposed to any issues or claims coming from occasions which take place after the original closing.

Due to the fact deed-in-lieu deals are more prone to challenge and dangers as laid out above, any title insurer issuing an owner's policy is most likely to carry out a more rigorous evaluation of the transaction during the underwriting procedure than they would in a normal third-party purchase and sale deal. The title insurer will inspect the celebrations and the deed-in-lieu files in order to identify and mitigate dangers provided by problems such as merger, obstructing, recharacterization and insolvency, therefore potentially increasing the time and expenses associated with closing the transaction, however eventually providing the lender with a higher level of protection than the lender would have missing the title business's involvement.
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Ultimately, whether a deed-in-lieu transaction is a viable alternative for a lending institution is driven by the specific realities and scenarios of not just the loan and the residential or commercial property, but the parties involved too. Under the right set of situations, therefore long as the correct due diligence and documents is acquired, a deed in lieu can provide the lending institution with a more effective and more economical ways to understand on its collateral 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 lawyer Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach attorney with whom you most regularly work.
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