When an industrial mortgage loan provider sets out to impose a mortgage loan following a borrower default, a key objective is to determine the most expeditious manner in which the loan provider can get control and ownership of the underlying collateral. Under the right set of scenarios, a deed in lieu of foreclosure can be a much faster and more cost-effective option to the long and drawn-out foreclosure procedure. This article talks about actions and issues loan providers ought to think about when making the choice to proceed with a deed in lieu of foreclosure and how to prevent unexpected risks and challenges during and following the deed-in-lieu procedure.
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Consideration

A crucial element of any agreement is guaranteeing there is adequate factor to consider. In a basic deal, factor to consider can quickly be developed through the purchase price, but in a deed-in-lieu situation, validating adequate consideration is not as straightforward.

In a deed-in-lieu circumstance, the amount of the underlying financial obligation that is being forgiven by the lender generally is the basis for the factor to consider, and in order for such factor to consider to be deemed "adequate," the debt should at least equivalent or go beyond the fair market value of the subject residential or commercial property. It is imperative that lenders obtain an independent third-party appraisal to substantiate the worth of the residential or commercial property in relation to the amount of financial obligation being forgiven. In addition, its recommended the deed-in-lieu agreement 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 potential claims associated with 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 borrower who protects a loan with a mortgage on real estate holds an unqualified right to redeem that residential or commercial property from the lending institution by repaying the debt up till the point when the right of redemption is lawfully snuffed out through a proper foreclosure. Preserving the debtor's fair right of redemption is the reason, 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 transactions prevent a debtor's equitable right of redemption, however, actions can be taken to structure them to restrict or avoid the risk of a clogging obstacle. First and primary, the reflection of the transfer of the residential or commercial property in lieu of a foreclosure should take place post-default and can not be contemplated by the underlying loan documents. Parties should likewise watch out for a deed-in-lieu plan where, following the transfer, there is a continuation of a debtor/creditor relationship, or which ponder that the customer retains rights to the residential or commercial property, either as a residential or commercial property manager, a renter or through repurchase choices, as any of these arrangements can create a risk of the transaction being recharacterized as an equitable mortgage.

Steps can be required to reduce against recharacterization threats. Some examples: if a customer's residential or commercial property management functions are limited to ministerial functions rather than substantive choice making, if a lease-back is brief term and the payments are clearly structured as market-rate usage and tenancy 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 recommended that deed-in-lieu contracts include the parties' clear and indisputable acknowledgement that the transfer of the residential or commercial property is an outright conveyance and not a transfer of for only.

Merger of Title

When a lender makes a loan secured by a mortgage on genuine estate, 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 real estate from a defaulting mortgagor, it now also holds an interest in the residential or commercial property by virtue of being the cost owner and obtaining the mortgagor's equity of redemption.

The general guideline on this issue supplies that, where a mortgagee obtains 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 lack of evidence of a contrary intent. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is very important the contract plainly reflects the celebrations' intent to keep the mortgage lien estate as distinct from the charge so the lender retains the capability to foreclose the hidden mortgage if there are intervening liens. If the estates combine, then the lender's mortgage lien is extinguished and the lending institution loses the capability to deal with intervening liens by foreclosure, which might leave the loan provider in a possibly even worse position than if the loan provider pursued a foreclosure from the start.

In order to clearly reflect the celebrations' intent on this point, the deed-in-lieu agreement (and the deed itself) must consist of reveal anti-merger language. Moreover, since there can be no mortgage without a debt, it is traditional in a deed-in-lieu situation for the loan provider to provide a covenant not to take legal action against, rather than a straight-forward release of the financial obligation. The covenant not to sue furnishes factor to consider for the deed in lieu, protects the borrower versus exposure from the debt and also keeps the lien of the mortgage, therefore allowing the loan provider to preserve the capability to foreclose, ought to it become desirable to get rid of junior encumbrances after the deed in lieu is total.

Transfer Tax

Depending upon 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 useful matter, the lender ends up absorbing the cost because the customer is in a default circumstance and generally lacks funds.

How transfer tax is calculated on a deed-in-lieu deal is dependent 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 debt. Some other states, consisting of Washington and Illinois, have uncomplicated exemptions for deed-in-lieu deals. In Connecticut, nevertheless, while there is an exemption for deed-in-lieu transactions it is limited only to a transfer of the debtor's individual house.

For a commercial deal, the tax will be computed based on the full purchase cost, which is expressly defined as consisting of the amount of liability which is presumed or to which the real estate is subject. Similarly, however much more possibly draconian, New york city bases the quantity of the transfer tax on "factor to consider," which is specified as the overdue balance of the debt, plus the overall amount of any other enduring liens and any quantities paid by the beneficiary (although if the loan is completely recourse, the consideration is capped at the reasonable market price of the residential or commercial property plus other quantities paid). Remembering the lending institution will, in many jurisdictions, need to pay this tax once again when eventually offering the residential or commercial property, the specific jurisdiction's guidelines on transfer tax can be a determinative element in deciding whether a deed-in-lieu transaction is a practical choice.

Bankruptcy Issues

A major concern for loan providers when determining if a deed in lieu is a practical option is the concern that if the borrower becomes a debtor in a personal 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 debt, 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 borrower was insolvent (or the transfer rendered the debtor insolvent) and within the 90-day duration stated in the Bankruptcy Code, the customer becomes 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 set aside if it is made within one year prior to an insolvency filing and the transfer was produced "less than a fairly equivalent worth" and if the transferor was insolvent at the time of the transfer, ended up being insolvent because of the transfer, was taken part in an organization that kept an unreasonably low level of capital or intended to incur debts beyond its capability to pay. In order to reduce against these dangers, a loan provider needs to thoroughly review and assess the borrower's monetary condition and liabilities and, preferably, require audited monetary statements to verify the solvency status of the borrower. Moreover, the deed-in-lieu arrangement needs to consist of representations as to solvency and a covenant from the borrower not to file for insolvency throughout the choice duration.

This is yet another reason it is crucial for a lending institution to procure an appraisal to confirm the value of the residential or commercial property in relation to the debt. An existing appraisal will help the loan provider refute any claims that the transfer was produced less than reasonably comparable value.

Title Insurance

As part of the initial acquisition of a genuine residential or commercial property, most owners and their loan providers will obtain policies of title insurance to protect their respective 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 depend on its lending institution's policy when it ends up being the charge owner. Coverage under a loan provider's policy of title insurance can continue after the acquisition of title if title is taken by the very same entity that is the called insured under the lending institution's policy.

Since lots of loan providers choose to have actually title vested in a different affiliate entity, in order to guarantee ongoing protection under the lending institution'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 alternative, the lending institution 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 a completely owned subsidiary (although in some jurisdictions this could set off transfer tax liability).

Notwithstanding the extension in coverage, a lending institution's policy does not convert to an owner's policy. Once the loan provider 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 offer the exact same or a sufficient level of security. Moreover, a loan provider's policy does not avail any protection for matters which develop after the date of the mortgage loan, leaving the loan provider exposed to any issues or claims coming from events which take place after the original closing.

Due to the fact deed-in-lieu transactions are more susceptible to challenge and dangers as detailed above, any title insurance company providing an owner's policy is likely to undertake a more rigorous evaluation of the deal throughout the underwriting procedure than they would in a normal third-party purchase and sale transaction. The title insurance company will scrutinize the celebrations and the deed-in-lieu files in order to identify and mitigate dangers presented by issues such as merger, clogging, recharacterization and insolvency, consequently possibly increasing the time and expenses included in closing the deal, but eventually providing the lending institution with a higher level of security than the loan provider would have absent the title business's involvement.

Ultimately, whether a deed-in-lieu deal is a feasible option for a lender is driven by the specific realities and scenarios of not only the loan and the residential or commercial property, however the parties included too. Under the right set of circumstances, and so long as the proper due diligence and documents is acquired, a deed in lieu can supply the loan provider with a more efficient and less pricey means to realize 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 require 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 regularly work.