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When an industrial mortgage loan provider sets out to enforce a mortgage loan following a debtor default, a crucial goal is to determine the most expeditious manner in which the lender can get control and belongings of the underlying security. Under the right set of circumstances, a deed in lieu of foreclosure can be a faster and more cost-effective option to the long and drawn-out foreclosure procedure. This post discusses actions and issues lenders must consider when making the decision to continue with a deed in lieu of foreclosure and how to prevent unforeseen threats and difficulties throughout and following the deed-in-lieu procedure.

Consideration

A key element of any contract is making sure there is sufficient factor to consider. In a basic deal, factor to consider can easily be developed through the purchase price, however in a deed-in-lieu situation, validating appropriate factor to consider is not as simple.

In a deed-in-lieu circumstance, the quantity of the underlying debt that is being forgiven by the loan provider typically is the basis for the factor to consider, and in order for such factor to consider to be deemed "adequate," the financial obligation ought to a minimum of equivalent or surpass the reasonable market price of the subject residential or commercial property. It is imperative that lenders obtain an independent third-party appraisal to corroborate the value of the residential or commercial property in relation to the quantity of financial obligation being forgiven. In addition, its suggested the deed-in-lieu agreement include the borrower's reveal acknowledgement of the fair market worth of the residential or commercial property in relation to the quantity of the debt and a waiver of any prospective claims related to the of the factor to consider.

Clogging and Recharacterization Issues

Clogging is shorthand for a primary rooted in ancient English typical law that a borrower who secures a loan with a mortgage on genuine estate holds an unqualified right to redeem that residential or commercial property from the loan provider by repaying the financial obligation up till the point when the right of redemption is legally snuffed out through a correct foreclosure. Preserving the debtor'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 lending institution.

Deed-in-lieu deals preclude a borrower's fair right of redemption, however, steps can be required to structure them to limit or avoid the risk of a clogging challenge. Primarily, the consideration of the transfer of the residential or commercial property in lieu of a foreclosure must take place post-default and can not be pondered by the underlying loan files. Parties must likewise be cautious of a deed-in-lieu arrangement where, following the transfer, there is an extension of a debtor/creditor relationship, or which ponder that the borrower maintains rights to the residential or commercial property, either as a residential or commercial property manager, a tenant or through repurchase choices, as any of these plans can produce a threat of the transaction being recharacterized as a fair mortgage.

Steps can be required to reduce against recharacterization risks. Some examples: if a borrower's residential or commercial property management functions are limited to ministerial functions rather than substantive choice 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 advised that deed-in-lieu contracts include the parties' clear and unequivocal recognition that the transfer of the residential or commercial property is an absolute conveyance and not a transfer of for security purposes just.

Merger of Title

When a lender makes a loan protected by a mortgage on realty, it holds an interest in the realty by virtue of being the mortgagee under a mortgage (or a recipient under a deed of trust). If the lending institution then obtains the genuine estate 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 general rule on this concern provides that, where a mortgagee gets 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 occurs in the lack of evidence of a contrary intent. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is necessary the agreement clearly shows the parties' intent to retain the mortgage lien estate as distinct from the charge so the loan provider keeps the capability to foreclose the hidden mortgage if there are intervening liens. If the estates merge, then the lending institution's mortgage lien is snuffed out and the loan provider loses the capability to handle stepping in liens by foreclosure, which might leave the loan provider in a potentially worse position than if the lending institution pursued a foreclosure from the beginning.

In order to plainly 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 customary in a deed-in-lieu scenario for the loan provider to deliver a covenant not to sue, rather than a straight-forward release of the debt. The covenant not to sue furnishes consideration for the deed in lieu, secures the borrower versus direct exposure from the debt and likewise maintains the lien of the mortgage, therefore allowing the loan provider to preserve the ability to foreclose, needs to it become preferable to get rid of 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 deals can be a substantial sticking point. While many states make the payment of transfer tax a seller commitment, as a useful matter, the loan provider ends up taking in the cost given that the debtor is in a default circumstance and typically lacks funds.

How transfer tax is determined on a deed-in-lieu deal is dependent on the jurisdiction and can be a driving force in identifying if a deed in lieu is a practical alternative. 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 as much as the amount of the financial obligation. Some other states, consisting of Washington and Illinois, have straightforward exemptions for deed-in-lieu transactions. In Connecticut, however, while there is an exemption for deed-in-lieu transactions it is restricted only to a transfer of the borrower's personal residence.

For a commercial transaction, the tax will be determined based upon the complete purchase cost, which is specifically specified as consisting of the quantity of liability which is presumed or to which the real estate is subject. Similarly, however much more possibly draconian, New York bases the quantity of the transfer tax on "consideration," which is specified as the unpaid balance of the financial obligation, plus the total quantity of any other enduring liens and any amounts paid by the grantee (although if the loan is completely recourse, the factor to consider is topped at the fair market price of the residential or commercial property plus other amounts paid). Remembering the lender will, in many jurisdictions, have to pay this tax once again when eventually offering 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 practical alternative.

Bankruptcy Issues

A major issue for loan providers when determining if a deed in lieu is a feasible option is the concern that if the customer ends up being a debtor in an insolvency case after the deed in lieu is total, the personal bankruptcy court can trigger 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 squarely within subsection (b)( 2) of Section 547 of the Bankruptcy Code handling preferential transfers. Accordingly, if the transfer was made when the customer was insolvent (or the transfer rendered the borrower insolvent) and within the 90-day period set forth in the Bankruptcy Code, the debtor becomes a debtor in a bankruptcy case, then the deed in lieu is at risk 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 an insolvency filing and the transfer was produced "less than a reasonably comparable worth" and if the transferor was insolvent at the time of the transfer, ended up being insolvent because of the transfer, was participated in a service that maintained an unreasonably low level of capital or intended to sustain financial obligations beyond its ability to pay. In order to alleviate versus these threats, a loan provider must thoroughly evaluate and evaluate the debtor's monetary condition and liabilities and, preferably, need audited financial statements to verify the solvency status of the customer. Moreover, the deed-in-lieu contract ought to consist of representations as to solvency and a covenant from the borrower not to file for bankruptcy during the preference period.

This is yet another reason that it is necessary for a lending institution to acquire an appraisal to validate the value of the residential or commercial property in relation to the debt. A present appraisal will help the lender refute any accusations that the transfer was made for less than fairly equivalent worth.

Title Insurance

As part of the initial acquisition of a genuine residential or commercial property, many owners and their loan providers will acquire policies of title insurance to secure their particular 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 count on its loan provider's policy when it ends up being the cost 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 lender's policy.

Since many loan providers choose to have title vested in a separate affiliate entity, in order to ensure ongoing coverage under the lending institution's policy, the called lender needs to designate the mortgage to the desired affiliate victor prior to, or simultaneously with, the transfer of the fee. In the alternative, the loan provider can take title and after that communicate the residential or commercial property by deed for no factor to consider to either its moms and dad company or a wholly owned subsidiary (although in some jurisdictions this might activate transfer tax liability).

Notwithstanding the continuation in protection, a lender's policy does not transform to an owner's policy. Once the lender 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 same or an adequate level of protection. Moreover, a loan provider's policy does not obtain any protection for matters which arise after the date of the mortgage loan, leaving the lending institution exposed to any problems or claims stemming from events which occur after the original closing.

Due to the truth deed-in-lieu transactions are more susceptible to challenge and dangers as detailed above, any title insurance provider issuing an owner's policy is most likely to carry out a more strenuous evaluation of the transaction during the underwriting process than they would in a common third-party purchase and sale deal. The title insurance company will inspect the parties and the deed-in-lieu documents in order to recognize and reduce risks presented by problems such as merger, blocking, recharacterization and insolvency, therefore potentially increasing the time and costs involved in closing the deal, but eventually providing the lending institution with a greater level of defense than the lender would have missing the title company's involvement.
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Ultimately, whether a deed-in-lieu transaction is a practical option for a lending institution is driven by the specific truths and scenarios of not only the loan and the residential or commercial property, but the parties included too. Under the right set of circumstances, therefore long as the proper due diligence and paperwork is obtained, a deed in lieu can supply the lending institution with a more effective and cheaper ways to realize on its collateral when a loan goes 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 reach out to lawyer Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach lawyer with whom you most often work.