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When a business mortgage lending institution sets out to impose a mortgage loan following a borrower default, a crucial goal is to recognize the most expeditious way 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 much faster and more cost-effective alternative to the long and lengthy foreclosure process. This short article talks about steps and issues loan providers should consider when making the decision to continue with a deed in lieu of foreclosure and how to avoid unanticipated dangers and challenges throughout and following the deed-in-lieu process.
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Consideration

A key element of any contract is guaranteeing there is sufficient consideration. In a standard transaction, factor to consider can easily be developed through the purchase rate, however in a deed-in-lieu situation, validating adequate consideration is not as straightforward.

In a deed-in-lieu circumstance, the quantity of the underlying debt that is being forgiven by the lender typically is the basis for the consideration, and in order for such factor to consider to be considered "appropriate," the debt ought to a minimum of equal or exceed the reasonable market value of the subject residential or commercial property. It is imperative that lending institutions obtain an independent third-party appraisal to corroborate the value of the residential or commercial property in relation to the quantity of debt being forgiven. In addition, its recommended the deed-in-lieu agreement include the debtor's express acknowledgement of the reasonable market price of the residential or commercial property in relation to the quantity of the debt 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 principal rooted in ancient English typical law that a borrower who secures a loan with a mortgage on property holds an right to redeem that residential or commercial property from the loan provider by repaying the debt up until 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 contemplate the voluntary transfer of the residential or commercial property to the lending institution.

Deed-in-lieu deals preclude a borrower's fair right of redemption, nevertheless, actions can be taken to structure them to limit or avoid the risk of a clogging obstacle. Firstly, the reflection of the transfer of the residential or commercial property in lieu of a foreclosure must take location post-default and can not be considered by the underlying loan documents. Parties should likewise be cautious of a deed-in-lieu plan where, following the transfer, there is a continuation of a debtor/creditor relationship, or which consider that the customer keeps rights to the residential or commercial property, either as a residential or commercial property supervisor, a renter or through repurchase choices, as any of these arrangements can create a risk of the deal being recharacterized as a fair mortgage.

Steps can be taken to reduce versus recharacterization threats. Some examples: if a customer's residential or commercial property management functions are limited to ministerial functions instead of substantive decision making, if a lease-back is brief term and the payments are clearly structured as market-rate use and tenancy payments, or if any arrangement for reacquisition of the residential or commercial property by the customer 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 unquestionable recognition that the transfer of the residential or commercial property is an outright conveyance and not a transfer of for security purposes just.

Merger of Title

When a lender makes a loan secured by a mortgage on property, it holds an interest in the property by virtue of being the mortgagee under a mortgage (or a recipient under a deed of trust). If the lending institution then gets the realty from a defaulting mortgagor, it now likewise 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 basic guideline on this problem provides that, where a mortgagee obtains 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 cost happens in the absence of proof of a contrary objective. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is very important the arrangement plainly shows the parties' intent to maintain the mortgage lien estate as distinct from the cost so the loan provider maintains the capability to foreclose the underlying mortgage if there are stepping in liens. If the estates merge, then the loan provider's mortgage lien is snuffed out and the loan provider loses the ability to handle stepping in liens by foreclosure, which might leave the lending institution in a potentially worse position than if the lender pursued a foreclosure from the beginning.

In order to clearly reflect the parties' intent on this point, the deed-in-lieu agreement (and the deed itself) ought to include express anti-merger language. Moreover, because there can be no mortgage without a debt, it is popular in a deed-in-lieu situation for the loan provider to deliver 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 customer versus direct exposure from the debt and also keeps the lien of the mortgage, thereby allowing the loan provider to preserve the capability to foreclose, should it end up being preferable to eliminate 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 transactions can be a substantial sticking point. While the majority of states make the payment of transfer tax a seller commitment, as a practical matter, the lender winds up soaking up the cost given that the customer remains in a default circumstance and normally lacks funds.

How transfer tax is calculated on a deed-in-lieu transaction is reliant on the jurisdiction and can be a driving force in identifying if a deed in lieu is a feasible option. In California, for example, 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 uncomplicated exemptions for deed-in-lieu deals. In Connecticut, nevertheless, while there is an exemption for deed-in-lieu deals it is restricted just to a transfer of the debtor's individual house.

For an industrial transaction, the tax will be computed based upon the full purchase price, which is specifically specified as including the amount of liability which is presumed or to which the real estate is subject. Similarly, however even more possibly draconian, New York bases the quantity of the transfer tax on "consideration," which is defined as the unpaid balance of the financial obligation, plus the overall amount of any other surviving liens and any quantities paid by the beneficiary (although if the loan is fully option, the factor to consider 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 once again when ultimately 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 transaction is a practical alternative.

Bankruptcy Issues

A significant concern for lending institutions when figuring out if a deed in lieu is a practical option is the concern that if the customer ends up being a debtor in an insolvency case after the deed in lieu is complete, the insolvency 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 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 debtor insolvent) and within the 90-day duration stated in the Bankruptcy Code, the customer ends up being a debtor in a personal bankruptcy case, then the deed in lieu is at danger of being reserved.

Similarly, under Section 548 of the Bankruptcy Code, a transfer can be reserved if it is made within one year prior to a bankruptcy filing and the transfer was made for "less than a fairly comparable value" and if the transferor was insolvent at the time of the transfer, became insolvent because of the transfer, was taken part in a business that kept an unreasonably low level of capital or meant to sustain financial obligations beyond its capability to pay. In order to reduce against these threats, a loan provider should carefully review and examine the debtor's financial condition and liabilities and, preferably, need audited monetary statements to verify the solvency status of the borrower. Moreover, the deed-in-lieu contract should include representations as to solvency and a covenant from the customer not to apply for bankruptcy during the preference duration.

This is yet another reason why it is imperative for a lender to obtain an appraisal to confirm the worth of the residential or commercial property in relation to the debt. An existing appraisal will help the lender refute any accusations that the transfer was made for less than reasonably equivalent value.

Title Insurance

As part of the preliminary acquisition of a real residential or commercial property, a lot of owners and their lenders will obtain policies of title insurance to protect 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 rely on its loan provider's policy when it ends up being the fee owner. Coverage under a lending institution's policy of title insurance can continue after the acquisition of title if title is taken by the exact same entity that is the called guaranteed under the loan provider's policy.

Since numerous lending institutions choose to have title vested in a separate affiliate entity, in order to make sure ongoing protection under the lending institution's policy, the named lender needs to designate the mortgage to the intended affiliate victor prior to, or simultaneously with, the transfer of the charge. In the alternative, the lending institution can take title and then communicate the residential or commercial property by deed for no factor to consider to either its moms and dad company or an entirely owned subsidiary (although in some jurisdictions this could activate transfer tax liability).

Notwithstanding the extension in protection, a lender'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 lending institution's policy would not offer the exact same or a sufficient level of security. Moreover, a lender's policy does not obtain any security for matters which emerge after the date of the mortgage loan, leaving the lender exposed to any problems or claims stemming from occasions which take place after the initial closing.

Due to the reality deed-in-lieu transactions are more vulnerable to challenge and dangers as detailed above, any title insurance provider releasing an owner's policy is most likely to carry out a more strenuous review of the transaction during the underwriting process than they would in a normal third-party purchase and sale deal. The title insurance provider will scrutinize the celebrations and the deed-in-lieu files in order to recognize and mitigate dangers provided by concerns such as merger, blocking, recharacterization and insolvency, therefore potentially increasing the time and costs included in closing the deal, however ultimately offering the lender with a higher level of security than the lender would have absent the title business's involvement.

Ultimately, whether a deed-in-lieu deal is a practical alternative for a lending institution is driven by the particular realities and circumstances of not just the loan and the residential or commercial property, however the parties involved also. Under the right set of situations, therefore long as the appropriate due diligence and documents is acquired, a deed in lieu can provide the lender with a more efficient and more economical means to realize on its collateral 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 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.