When a commercial mortgage lending institution sets out to impose a mortgage loan following a debtor default, a key objective is to determine the most expeditious manner in which the lender can get control and possession of the underlying security. 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 lengthy foreclosure procedure. This post talks about actions and issues lenders need to consider when making the decision to proceed with a deed in lieu of foreclosure and how to prevent unanticipated threats and difficulties throughout and following the deed-in-lieu procedure.

Consideration

A crucial element of any contract is making sure there is sufficient consideration. In a basic deal, factor to consider can quickly be developed through the purchase price, however in a deed-in-lieu circumstance, confirming sufficient consideration is not as uncomplicated.

In a deed-in-lieu scenario, the quantity of the underlying financial obligation that is being forgiven by the lending institution typically is the basis for the factor to consider, and in order for such consideration to be deemed "adequate," the debt should a minimum of equivalent or exceed the reasonable market worth of the subject residential or commercial property. It is vital that lending institutions 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 suggested the deed-in-lieu arrangement include the customer's reveal recognition of the reasonable market price of the residential or commercial property in relation to the amount of the financial obligation and a waiver of any potential claims connected to the adequacy of the factor to consider.

Clogging and Recharacterization Issues

Clogging is shorthand for a principal rooted in ancient English common law that a borrower who secures a loan with a mortgage on property holds an unqualified right to redeem that residential or commercial property from the loan provider by paying back the financial obligation up till the point when the right of redemption is lawfully snuffed out through a proper foreclosure. Preserving the customer'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 lending institution.

Deed-in-lieu deals preclude a borrower's equitable right of redemption, however, steps can be taken to structure them to limit or avoid the threat of a blocking obstacle. Firstly, the contemplation of the transfer of the residential or commercial property in lieu of a foreclosure must occur post-default and can not be contemplated by the underlying loan documents. Parties need to also be careful of a deed-in-lieu plan where, following the transfer, there is a continuation of a debtor/creditor relationship, or which ponder that the debtor keeps rights to the residential or commercial property, either as a residential or commercial property supervisor, an occupant or through repurchase options, as any of these plans can create a danger of the deal being recharacterized as an equitable mortgage.
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Steps can be required to mitigate versus recharacterization risks. Some examples: if a debtor's residential or commercial property management functions are limited to ministerial functions rather than substantive decision making, if a lease-back is short term and the payments are clearly structured as market-rate use and occupancy payments, or if any arrangement for reacquisition of the residential or commercial property by the debtor is set up to be completely independent of the condition for the deed in lieu.

While not determinative, it is suggested that deed-in-lieu contracts include the parties' 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 real estate, it holds an interest in the realty by virtue of being the mortgagee under a mortgage (or a recipient under a deed of trust). If the loan provider then acquires the genuine estate 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 general rule on this issue provides 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 cost takes place in the lack of proof of a contrary intent. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is necessary the agreement clearly reflects the parties' intent to maintain the mortgage lien estate as distinct from the charge so the lending institution keeps the ability to foreclose the underlying mortgage if there are intervening liens. If the estates merge, then the lending institution's mortgage lien is extinguished and the loan provider loses the capability to handle intervening liens by foreclosure, which might leave the loan provider in a potentially worse position than if the loan provider pursued a foreclosure from the beginning.

In order to clearly show the parties' intent on this point, the deed-in-lieu arrangement (and the deed itself) should include reveal anti-merger language. Moreover, because there can be no mortgage without a debt, it is traditional in a deed-in-lieu circumstance for the lender to provide 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, protects the debtor versus exposure from the financial obligation and likewise keeps the lien of the mortgage, thereby enabling the loan provider to keep the ability to foreclose, should it become desirable to eliminate junior encumbrances after the deed in lieu is complete.

Transfer Tax

Depending upon 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 useful matter, the lending institution ends up taking in the cost considering that the borrower is in a default circumstance and normally 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 practical alternative. In California, for example, a conveyance or transfer from the mortgagor to the mortgagee as an outcome of a foreclosure or a deed in lieu will be exempt approximately the amount of the financial obligation. Some other states, including Washington and Illinois, have uncomplicated exemptions for deed-in-lieu transactions. In Connecticut, however, while there is an exemption for deed-in-lieu transactions it is limited just to a transfer of the borrower's individual home.

For a commercial deal, the tax will be determined based on the complete purchase rate, which is specifically specified as consisting of the quantity of liability which is presumed or to which the real estate is subject. Similarly, however much more possibly heavy-handed, New York bases the quantity of the transfer tax on "consideration," which is specified as the overdue balance of the financial obligation, plus the overall quantity of any other making it through liens and any quantities paid by the grantee (although if the loan is completely recourse, the factor to consider is topped at the fair market value of the residential or commercial property plus other quantities paid). Bearing in mind the loan provider will, in most jurisdictions, need to pay this tax once again when ultimately offering the residential or commercial property, the specific jurisdiction's guidelines on transfer tax can be a determinative element in choosing whether a deed-in-lieu transaction is a practical choice.

Bankruptcy Issues

A major concern for lending institutions when determining if a deed in lieu is a feasible alternative is the issue that if the borrower ends up being a debtor in a bankruptcy case after the deed in lieu is complete, the personal bankruptcy court can trigger the transfer to be unwound or reserved. 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 customer was insolvent (or the transfer rendered the borrower insolvent) and within the 90-day duration stated in the Bankruptcy Code, the debtor becomes a debtor in a personal bankruptcy case, then the deed in lieu is at threat 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 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, became insolvent since of the transfer, was engaged in an organization that kept an unreasonably low level of capital or meant to sustain financial obligations beyond its capability to pay. In order to mitigate versus these risks, a loan provider needs to carefully evaluate and evaluate the debtor's monetary condition and liabilities and, ideally, require audited financial declarations to confirm the solvency status of the borrower. Moreover, the deed-in-lieu contract ought to include representations regarding solvency and a covenant from the debtor not to apply for bankruptcy during the preference period.

This is yet another reason that it is important for a loan provider to obtain an appraisal to confirm the worth of the residential or commercial property in relation to the financial obligation. A present appraisal will assist the lending institution refute any accusations that the transfer was produced less than fairly equivalent value.

Title Insurance

As part of the initial acquisition of a genuine residential or commercial property, the majority of owners and their loan providers will get policies of title insurance coverage to secure their particular interests. A lending institution thinking about taking title to a residential or commercial property by virtue of a deed in lieu might ask whether it can count on its lender's policy when it becomes 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 insured under the loan provider's policy.

Since lots of loan providers prefer to have title vested in a different affiliate entity, in order to make sure continued coverage under the lending institution's policy, the called loan provider should designate the mortgage to the designated affiliate title holder prior to, or all at once with, the transfer of the fee. In the alternative, the loan provider can take title and after that communicate the residential or commercial property by deed for no factor to consider to either its parent company or an entirely owned subsidiary (although in some jurisdictions this might activate transfer tax liability).
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the extension in protection, a loan provider'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 loan provider's policy would not provide the same or a sufficient level of defense. Moreover, a lending institution's policy does not avail any security for matters which arise after the date of the mortgage loan, leaving the loan provider exposed to any problems or claims originating from occasions which happen after the original closing.

Due to the fact deed-in-lieu transactions are more prone to challenge and dangers as outlined above, any title insurance provider releasing an owner's policy is likely to carry out a more rigorous evaluation of the deal throughout the underwriting process than they would in a typical third-party purchase and sale transaction. The title insurance company will inspect the celebrations and the deed-in-lieu documents in order to identify and alleviate risks presented by problems such as merger, blocking, recharacterization and insolvency, therefore possibly increasing the time and expenses included in closing the transaction, however ultimately supplying the lending institution with a greater level of protection than the loan provider would have missing the title business's involvement.

Ultimately, whether a deed-in-lieu transaction is a feasible option for a lending institution is driven by the specific facts and scenarios of not only the loan and the residential or commercial property, but the parties involved too. Under the right set of situations, therefore long as the proper due diligence and documentation is acquired, a deed in lieu can supply the lender with a more efficient and more economical ways to recognize 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 support with such matters, please reach out to attorney Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach attorney with whom you most regularly work.