When an industrial mortgage lender sets out to enforce a mortgage loan following a customer default, a crucial objective is to recognize the most expeditious manner in which the lender can obtain control and ownership of the underlying collateral. Under the right set of scenarios, a deed in lieu of foreclosure can be a faster and more cost-effective alternative to the long and protracted foreclosure procedure. This short article discusses actions and issues lending institutions ought to think about when making the choice to continue with a deed in lieu of foreclosure and how to prevent unexpected threats and difficulties during and following the deed-in-lieu process.

Consideration

A crucial component of any agreement is guaranteeing there is adequate consideration. In a standard deal, consideration can easily be established through the purchase price, however in a deed-in-lieu circumstance, confirming adequate factor to consider is not as uncomplicated.

In a deed-in-lieu scenario, the amount of the underlying debt that is being forgiven by the loan provider normally is the basis for the factor to consider, and in order for such factor to consider to be deemed "adequate," the financial obligation needs to a minimum of equal or go beyond the fair market price of the subject residential or commercial property. It is necessary that lenders obtain an independent third-party appraisal to substantiate the value 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 include the borrower's express acknowledgement of the fair market price of the residential or commercial property in relation to the amount of the debt and a waiver of any prospective claims related to the adequacy of the consideration.

Clogging and Recharacterization Issues

Clogging is shorthand for a primary rooted in ancient English common law that a customer who secures a loan with a mortgage on property holds an unqualified right to redeem that residential or commercial property from the lender by paying back the debt up till the point when the right of redemption is lawfully extinguished through a proper foreclosure. Preserving the borrower's fair 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 loan provider.

Deed-in-lieu deals prevent a borrower's fair right of redemption, however, steps can be required to structure them to restrict or prevent the risk of a clogging difficulty. Most importantly, the consideration of the transfer of the residential or commercial property in lieu of a foreclosure should happen post-default and can not be considered by the underlying loan documents. Parties ought to 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 customer maintains rights to the residential or commercial property, either as a residential or commercial property manager, a tenant or through repurchase alternatives, as any of these arrangements can produce a threat of the deal being recharacterized as an equitable mortgage.

Steps can be required to reduce versus recharacterization risks. Some examples: if a borrower's residential or commercial property management functions are restricted to ministerial functions rather than substantive decision making, if a lease-back is short term and the payments are plainly structured as market-rate use and occupancy 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 agreements include the parties' clear and indisputable recognition that the transfer of the residential or commercial property is an outright conveyance and not a transfer of for security functions just.

Merger of Title

When a loan provider 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 beneficiary under a deed of trust). If the lender then acquires 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 obtaining the mortgagor's equity of redemption.

The basic rule on this problem offers 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 happens in the absence of evidence of a contrary objective. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is essential the contract clearly shows the celebrations' intent to retain the mortgage lien estate as distinct from the charge so the lender retains the capability to foreclose the hidden mortgage if there are stepping in liens. If the estates merge, then the loan provider's mortgage lien is extinguished and the lender loses the ability to handle stepping in liens by foreclosure, which might leave the lending institution in a possibly worse position than if the loan provider pursued a foreclosure from the beginning.

In order to plainly show the celebrations' intent on this point, the deed-in-lieu agreement (and the deed itself) should consist of reveal anti-merger language. Moreover, because there can be no mortgage without a debt, it is customary in a deed-in-lieu circumstance for the lender to provide a covenant not to take legal action against, instead of 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 borrower versus exposure from the financial obligation and likewise retains the lien of the mortgage, thereby allowing the lender to keep the ability to foreclose, should it become desirable to eliminate junior encumbrances after the deed in lieu is total.

Transfer Tax

Depending on the jurisdiction, handling transfer tax and the payment thereof in deed-in-lieu transactions can be a significant sticking point. While most states make the payment of transfer tax a seller obligation, as a useful matter, the lending institution ends up taking in the expense considering that the customer is in a default scenario and usually lacks funds.

How transfer tax is calculated 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 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 up to the quantity of the financial obligation. Some other states, including Washington and Illinois, have straightforward exemptions for deed-in-lieu deals. In Connecticut, nevertheless, while there is an exemption for deed-in-lieu transactions it is limited just to a transfer of the debtor's individual residence.

For a commercial deal, the tax will be computed based on the complete purchase price, which is expressly defined as consisting of the quantity of liability which is assumed or to which the real estate is subject. Similarly, however a lot more potentially severe, New York bases the quantity of the transfer tax on "consideration," which is specified as the unpaid balance of the debt, 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 consideration is topped at the fair market price of the residential or commercial property plus other quantities paid). Keeping in mind the lender will, in a lot of jurisdictions, have to pay this tax again when eventually selling the residential or commercial property, the particular jurisdiction's guidelines on transfer tax can be a determinative consider deciding whether a deed-in-lieu deal is a possible option.

Bankruptcy Issues

A significant issue for loan providers when figuring out if a deed in lieu is a practical alternative is the issue that if the debtor becomes a debtor in a 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 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 dealing with preferential transfers. Accordingly, if the transfer was made when the borrower was insolvent (or the transfer rendered the customer insolvent) and within the 90-day period set forth in the Bankruptcy Code, the customer becomes 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 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, became insolvent since of the transfer, was participated in a business that preserved an level of capital or intended to sustain financial obligations beyond its capability to pay. In order to mitigate against these threats, a loan provider must thoroughly review and evaluate the customer's financial condition and liabilities and, preferably, require audited monetary declarations to verify the solvency status of the customer. Moreover, the deed-in-lieu contract must consist of representations regarding solvency and a covenant from the borrower not to submit for insolvency during the preference duration.

This is yet another reason it is vital for a loan provider to obtain an appraisal to verify the value of the residential or commercial property in relation to the debt. A present appraisal will assist the lender refute any allegations that the transfer was made for less than reasonably equivalent value.

Title Insurance

As part of the initial acquisition of a real residential or commercial property, many owners and their lending institutions will get policies of title insurance to safeguard their respective interests. A lending institution considering 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 becomes the cost owner. Coverage under a lender's policy of title insurance can continue after the acquisition of title if title is taken by the same entity that is the called guaranteed under the lender's policy.

Since many loan providers choose to have actually title vested in a separate affiliate entity, in order to guarantee continued protection under the lender's policy, the called loan provider needs to designate the mortgage to the intended affiliate title holder prior to, or all at once with, the transfer of the cost. In the alternative, the loan provider can take title and then convey the residential or commercial property by deed for no consideration to either its parent company or a wholly owned subsidiary (although in some jurisdictions this might set off transfer tax liability).

Notwithstanding the extension in protection, a loan provider's policy does not transform 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 lender's policy would not provide the same or an appropriate level of defense. Moreover, a loan provider's policy does not get any protection for matters which emerge 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 truth deed-in-lieu deals are more susceptible to challenge and dangers as detailed above, any title insurance provider issuing an owner's policy is most likely to undertake a more strenuous evaluation of the transaction throughout the underwriting procedure than they would in a common third-party purchase and sale deal. The title insurer will inspect the celebrations and the deed-in-lieu documents in order to determine and reduce threats provided by problems such as merger, obstructing, recharacterization and insolvency, thereby possibly increasing the time and expenses included in closing the transaction, but eventually providing the loan provider with a greater level of defense than the lender would have absent the title company's involvement.

Ultimately, whether a deed-in-lieu deal is a viable option 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 situations, and so long as the proper due diligence and documentation is acquired, a deed in lieu can offer the lender with a more efficient and cheaper means to realize 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 assistance 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 often work.
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