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When an industrial mortgage loan provider sets out to impose a mortgage loan following a borrower default, a crucial objective is to identify the most expeditious way in which the lending institution can obtain control and possession of the underlying security. Under the right set of circumstances, a deed in lieu of foreclosure can be a faster and more economical option to the long and lengthy foreclosure process. This post discusses actions and issues lenders need to think about when deciding to continue with a deed in lieu of foreclosure and how to prevent unexpected dangers and challenges throughout and following the deed-in-lieu procedure.
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Consideration

A crucial element of any contract is guaranteeing there is appropriate consideration. In a basic deal, consideration can quickly be developed through the purchase price, however in a deed-in-lieu situation, validating sufficient consideration is not as straightforward.

In a deed-in-lieu situation, the quantity of the underlying debt that is being by the lending institution usually is the basis for the factor to consider, and in order for such consideration to be deemed "adequate," the debt should at least equal or surpass the reasonable market worth of the subject residential or commercial property. It is essential that lending institutions obtain an independent third-party appraisal to validate the worth of the residential or commercial property in relation to the amount of financial obligation being forgiven. In addition, its advised the deed-in-lieu agreement include the borrower's express recognition of the fair market value of the residential or commercial property in relation to the quantity of the debt 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 debtor who protects a loan with a mortgage on property holds an unqualified right to redeem that residential or commercial property from the lender by repaying the financial obligation up till the point when the right of redemption is legally snuffed out through a correct foreclosure. Preserving the customer's equitable right of redemption is the reason, prior to default, mortgage loans can not be structured to ponder the voluntary transfer of the residential or commercial property to the loan provider.

Deed-in-lieu deals prevent a customer's fair right of redemption, however, steps can be taken to structure them to restrict or prevent the risk of a clogging challenge. Primarily, the consideration of the transfer of the residential or commercial property in lieu of a foreclosure should take place post-default and can not be considered by the underlying loan files. 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 ponder that the customer keeps rights to the residential or commercial property, either as a residential or commercial property supervisor, an occupant or through repurchase alternatives, as any of these plans can create a risk of the transaction being recharacterized as an equitable mortgage.

Steps can be taken to alleviate against recharacterization threats. Some examples: if a borrower'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 plainly structured as market-rate use and occupancy payments, or if any provision for reacquisition of the residential or commercial property by the borrower is established to be completely independent of the condition for the deed in lieu.

While not determinative, it is suggested that deed-in-lieu agreements include 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 loan provider makes a loan secured by a mortgage on property, it holds an interest in the real estate by virtue of being the mortgagee under a mortgage (or a beneficiary under a deed of trust). If the lending institution then acquires the real estate from a defaulting mortgagor, it now likewise holds an interest in the residential or commercial property by virtue of being the fee owner and getting the mortgagor's equity of redemption.

The basic guideline on this concern 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 takes place in the absence of evidence of a contrary intention. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is very important the arrangement plainly reflects the parties' intent to maintain the mortgage lien estate as distinct from the cost so the lender maintains the ability to foreclose the hidden mortgage if there are intervening liens. If the estates combine, then the lender's mortgage lien is snuffed out and the loan provider loses the ability to deal with intervening liens by foreclosure, which might leave the lender in a potentially worse position than if the lending institution pursued a foreclosure from the start.

In order to clearly reflect the parties' intent on this point, the deed-in-lieu arrangement (and the deed itself) must include reveal anti-merger language. Moreover, since there can be no mortgage without a debt, it is popular in a deed-in-lieu situation for the lending institution to provide a covenant not to sue, 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, protects the customer versus exposure from the debt and likewise keeps the lien of the mortgage, thus permitting the lender to maintain the ability to foreclose, needs to it end up being desirable to remove junior encumbrances after the deed in lieu is complete.

Transfer Tax

Depending upon the jurisdiction, dealing with transfer tax and the payment thereof in deed-in-lieu transactions can be a substantial sticking point. While the majority of states make the payment of transfer tax a seller responsibility, as a practical matter, the lending institution winds up soaking up the expense considering that the debtor is in a default situation and usually 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 viable option. In California, for instance, a conveyance or transfer from the mortgagor to the mortgagee as a result of a foreclosure or a deed in lieu will be exempt approximately the quantity of the debt. Some other states, including Washington and Illinois, have straightforward exemptions for deed-in-lieu transactions. In Connecticut, nevertheless, while there is an exemption for deed-in-lieu transactions it is limited only to a transfer of the debtor's personal house.

For a business deal, the tax will be calculated based upon the full purchase price, which is expressly defined as including the amount of liability which is presumed or to which the real estate is subject. Similarly, but a lot more possibly severe, New york city bases the quantity of the transfer tax on "consideration," which is defined as the unsettled balance of the debt, plus the overall amount of any other surviving liens and any amounts paid by the beneficiary (although if the loan is totally recourse, the consideration is capped at the reasonable 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 eventually offering 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 choice.

Bankruptcy Issues

A major issue for lenders when determining if a deed in lieu is a feasible alternative is the concern that if the debtor ends up being 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 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 debtor was insolvent (or the transfer rendered the borrower 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 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 comparable value" and if the transferor was insolvent at the time of the transfer, ended up being insolvent because of the transfer, was taken part in a company that kept an unreasonably low level of capital or meant to incur debts beyond its ability to pay. In order to mitigate versus these risks, a loan provider must carefully review and assess the borrower's monetary condition and liabilities and, preferably, require audited monetary declarations to verify the solvency status of the customer. Moreover, the deed-in-lieu agreement needs to include representations regarding solvency and a covenant from the customer not to apply for personal bankruptcy throughout the choice period.

This is yet another reason it is necessary for a lender to procure an appraisal to confirm the value of the residential or commercial property in relation to the debt. A current appraisal will assist the loan provider 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 lenders will obtain policies of title insurance coverage to secure their particular interests. A loan provider thinking about taking title to a residential or commercial property by virtue of a deed in lieu may ask whether it can count 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 lending institution's policy.

Since lots of lending institutions choose to have title vested in a different affiliate entity, in order to guarantee ongoing coverage under the lending institution's policy, the named lending institution ought to appoint the mortgage to the intended affiliate title holder prior to, or concurrently with, the transfer of the fee. 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 business or an entirely owned subsidiary (although in some jurisdictions this might set off transfer tax liability).

Notwithstanding the continuation in protection, a lending institution's policy does not convert to an owner's policy. Once the lender 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 very same or a sufficient level of protection. Moreover, a lender's policy does not avail any protection for matters which occur after the date of the mortgage loan, leaving the lender exposed to any concerns or claims stemming from events which take place after the initial closing.

Due to the truth deed-in-lieu deals are more prone to challenge and risks as laid out above, any title insurance provider issuing an owner's policy is likely to undertake a more rigorous review of the transaction throughout the underwriting procedure than they would in a common third-party purchase and sale transaction. The title insurance company will scrutinize the celebrations and the deed-in-lieu documents in order to determine and reduce dangers presented by concerns such as merger, clogging, recharacterization and insolvency, consequently potentially increasing the time and costs associated with closing the deal, but eventually supplying the lending institution with a higher level of protection than the lending institution would have absent the title company's participation.
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Ultimately, whether a deed-in-lieu deal is a feasible option for a loan provider is driven by the specific facts and circumstances 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 correct due diligence and documents is gotten, a deed in lieu can provide the lender with a more efficient and more economical means to recognize on its security 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 reach out to attorney Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach lawyer with whom you most often work.