When a business mortgage lending institution sets out to enforce a mortgage loan following a customer default, a key objective is to identify the most expeditious manner in which the loan provider 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 article discusses actions and issues lenders ought to think about when making the decision to proceed with a deed in lieu of foreclosure and how to prevent unexpected dangers and difficulties during and following the deed-in-lieu procedure.

Consideration

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

In a deed-in-lieu situation, the amount of the underlying debt that is being forgiven by the lender typically is the basis for the factor to consider, and in order for such consideration to be considered "adequate," the debt should a minimum of equivalent or exceed the reasonable market price of the subject residential or commercial property. It is important that lending institutions acquire an independent third-party appraisal to corroborate the worth of the residential or commercial property in relation to the quantity of financial obligation being forgiven. In addition, its recommended the deed-in-lieu agreement consist of the borrower's express acknowledgement of the reasonable market value of the residential or commercial property in relation to the amount of the financial obligation and a waiver of any potential claims related to the adequacy of the factor to consider.

Clogging and Recharacterization Issues

Clogging is shorthand for a primary rooted in ancient English typical 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 repaying the financial obligation up till the point when the right of redemption is lawfully extinguished through a correct foreclosure. Preserving the borrower'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 preclude a borrower's fair right of redemption, nevertheless, actions can be taken to structure them to limit or avoid the risk of a blocking challenge. Most importantly, the contemplation of the transfer of the residential or commercial property in lieu of a foreclosure need to take location post-default and can not be contemplated by the underlying loan documents. Parties must also watch out for a deed-in-lieu arrangement where, following the transfer, there is an extension 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 manager, an occupant or through repurchase choices, as any of these arrangements can create a danger of the transaction being recharacterized as a fair mortgage.

Steps can be taken to alleviate versus recharacterization dangers. Some examples: if a borrower's residential or commercial property management functions are restricted to ministerial functions rather than substantive choice making, if a lease-back is short term and the payments are 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 advised that deed-in-lieu arrangements consist of the celebrations' clear and unquestionable acknowledgement that the transfer of the residential or commercial property is an outright 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 property, it holds an interest in the genuine estate by virtue of being the mortgagee under a mortgage (or a beneficiary under a deed of trust). If the loan provider then gets the genuine estate 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 basic rule on this problem provides 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 occurs in the absence of evidence of a contrary intention. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is necessary the contract plainly reflects the parties' intent to maintain the mortgage lien estate as distinct from the cost so the lender maintains the capability to foreclose the hidden mortgage if there are intervening liens. If the estates merge, then the lending institution's mortgage lien is extinguished and the lender loses the ability to deal with stepping in liens by foreclosure, which could leave the lending institution in a possibly even worse position than if the loan provider pursued a foreclosure from the start.

In order to plainly show the celebrations' intent on this point, the deed-in-lieu agreement (and the deed itself) need to consist of express anti-merger language. Moreover, since there can be no mortgage without a financial obligation, it is popular in a deed-in-lieu situation for the lender to deliver a covenant not to sue, instead of a straight-forward release of the debt. The covenant not to take legal action against furnishes consideration for the deed in lieu, protects the customer against exposure from the financial obligation and likewise retains the lien of the mortgage, therefore enabling the lending institution to preserve the capability to foreclose, needs to it end up being desirable to get rid of junior encumbrances after the deed in lieu is complete.

Transfer Tax

Depending on the jurisdiction, handling transfer tax and the payment thereof in deed-in-lieu deals can be a significant sticking point. While a lot of states make the payment of transfer tax a seller commitment, as a practical matter, the lending institution winds up taking in the expense given that the borrower remains in a default scenario and normally lacks funds.

How transfer tax is computed on a deed-in-lieu deal depends on the jurisdiction and can be a driving force in identifying if a deed in lieu is a viable option. 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 up to 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 deals it is restricted just to a transfer of the borrower's individual home.

For a commercial transaction, the tax will be computed based upon the full purchase cost, which is expressly specified as including the quantity of liability which is presumed or to which the real estate is subject. Similarly, but much more possibly heavy-handed, New York bases the quantity of the transfer tax on "consideration," which is defined as the unpaid balance of the debt, plus the overall quantity of any other surviving liens and any amounts paid by the beneficiary (although if the loan is completely recourse, the factor to consider is capped at the fair market price of the residential or commercial property plus other quantities paid). Remembering the lending institution will, in most jurisdictions, have to pay this tax again when ultimately selling the residential or commercial property, the specific jurisdiction's guidelines on transfer tax can be a determinative consider deciding whether a deed-in-lieu deal is a practical option.

Bankruptcy Issues

A significant concern for lenders when determining if a deed in lieu is a feasible option is the issue that if the customer becomes a debtor in a personal bankruptcy 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 customer was insolvent (or the transfer rendered the debtor insolvent) and within the 90-day duration set forth in the Bankruptcy Code, the debtor becomes a debtor in an insolvency 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 produced "less than a fairly equivalent value" and if the transferor was insolvent at the time of the transfer, became insolvent since of the transfer, was participated in an organization that kept an unreasonably low level of capital or intended to sustain debts beyond its ability to pay. In order to reduce versus these dangers, a loan provider needs to carefully examine and examine the debtor's monetary condition and liabilities and, ideally, need audited monetary statements to verify the solvency status of the borrower. Moreover, the deed-in-lieu arrangement ought to consist of representations regarding solvency and a covenant from the borrower not to declare bankruptcy during the choice duration.

This is yet another reason it is crucial for a lending institution to acquire an appraisal to confirm the value of the residential or commercial property in relation to the financial obligation. An existing appraisal will help the lender refute any accusations that the transfer was produced less than reasonably equivalent worth.

Title Insurance

As part of the preliminary acquisition of a real residential or commercial property, the majority of owners and their lending institutions will get policies of title insurance coverage to protect their particular interests. A lending institution thinking about taking title to a residential or commercial property by virtue of a deed in lieu may ask whether it can rely on its lending institution's policy when it becomes the cost 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 guaranteed under the loan provider's policy.

Since many lenders prefer to have actually title vested in a different affiliate entity, in order to ensure ongoing coverage under the lending institution's policy, the named lender should appoint the mortgage to the intended affiliate victor prior to, or concurrently with, the transfer of the charge. In the alternative, the lending institution can take title and then convey the residential or commercial property by deed for no consideration to either its moms and dad business or an entirely owned subsidiary (although in some jurisdictions this could trigger transfer tax liability).

Notwithstanding the extension in protection, 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 lending institution's policy would not provide the exact same or a sufficient level of security. Moreover, a lending institution's policy does not obtain any defense for matters which develop after the date of the mortgage loan, leaving the loan provider exposed to any problems or claims stemming from events which happen after the initial closing.

Due to the reality deed-in-lieu deals are more susceptible to challenge and threats as described above, any title insurance provider issuing an owner's policy is most likely to carry out a more extensive evaluation of the transaction during the underwriting process than they would in a typical third-party purchase and sale transaction. The title insurer will scrutinize the parties and the deed-in-lieu documents in order to determine and reduce dangers provided by concerns such as merger, obstructing, recharacterization and insolvency, thereby potentially increasing the time and expenses involved in closing the deal, but eventually supplying the lender with a greater level of protection than the lender would have absent the title business's participation.

Ultimately, whether a deed-in-lieu deal is a feasible alternative for a lender is driven by the particular realities and situations of not only the loan and the residential or commercial property, however the parties included too. Under the right set of circumstances, therefore long as the correct due diligence and documentation is obtained, a deed in lieu can offer the loan provider with a more efficient and less costly methods to understand on its security when a loan enters 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 attorney with whom you most regularly work.
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