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When a commercial mortgage lending institution sets out to impose a mortgage loan following a customer default, a crucial goal is to identify the most expeditious way in which the lender can get control and possession of the underlying collateral. Under the right set of scenarios, a deed in lieu of foreclosure can be a much faster and more affordable alternative to the long and drawn-out foreclosure process. This short article discusses actions and concerns lending institutions should consider when deciding to proceed with a deed in lieu of foreclosure and how to prevent unanticipated dangers and challenges throughout and following the deed-in-lieu process.

Consideration

A crucial component of any agreement is ensuring there is appropriate consideration. In a standard deal, factor to consider can easily be established through the purchase cost, however in a deed-in-lieu circumstance, validating sufficient consideration is not as simple.

In a deed-in-lieu scenario, the amount of the underlying financial obligation that is being forgiven by the lender normally is the basis for the factor to consider, and in order for such consideration to be considered "sufficient," the financial obligation should a minimum of equivalent or exceed the fair market value of the subject residential or commercial property. It is essential that lenders obtain an independent third-party appraisal to validate 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 consist of the customer's express recognition of the reasonable market price of the residential or commercial property in relation to the amount of the financial obligation 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 typical law that a debtor who secures a loan with a mortgage on property holds an unqualified right to redeem that residential or commercial property from the lender by repaying the debt up till the point when the right of redemption is lawfully extinguished through an appropriate foreclosure. Preserving the borrower's fair right of redemption is the reason that, 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 transactions preclude a debtor's fair right of redemption, nevertheless, actions can be required to structure them to restrict or prevent the danger of an obstructing challenge. Primarily, the contemplation of the transfer of the residential or commercial property in lieu of a foreclosure need to occur post-default and can not be pondered by the underlying loan documents. Parties should also be wary of a deed-in-lieu arrangement where, following the transfer, there is an extension of a debtor/creditor relationship, or which contemplate that the borrower 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 arrangements can create a threat of the deal being recharacterized as a fair mortgage.

Steps can be taken to mitigate against recharacterization threats. Some examples: if a borrower's residential or commercial property management functions are restricted 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 occupancy payments, or if any provision for reacquisition of the residential or commercial property by the customer 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 consist of the parties' clear and unequivocal acknowledgement that the transfer of the residential or commercial property is an absolute 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 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 loan provider 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 obtaining the mortgagor's equity of redemption.

The general guideline on this issue supplies 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 happens in the absence of proof of a contrary objective. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is very important the arrangement clearly reflects the parties' intent to keep the mortgage lien estate as distinct from the fee so the lender keeps the ability to foreclose the hidden mortgage if there are stepping in liens. If the estates combine, then the loan provider's mortgage lien is extinguished and the loan provider loses the capability to deal with intervening liens by foreclosure, which might leave the lending institution in a potentially even worse position than if the lending institution pursued a foreclosure from the outset.

In order to clearly reflect the parties' intent on this point, the deed-in-lieu agreement (and the deed itself) must include reveal anti-merger language. Moreover, because there can be no mortgage without a debt, it is popular in a deed-in-lieu scenario for the lender to deliver a covenant not to sue, rather than a straight-forward release of the debt. The covenant not to sue furnishes factor to consider for the deed in lieu, secures the debtor against direct exposure from the financial obligation and also maintains the lien of the mortgage, consequently allowing the lender to preserve the ability to foreclose, ought to it end up being 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 transactions can be a substantial sticking point. While a lot of states make the payment of transfer tax a seller responsibility, as a useful matter, the lending institution winds up soaking up the cost considering that the customer is in a default situation and typically lacks funds.

How transfer tax is computed on a deed-in-lieu transaction depends on the jurisdiction and can be a driving force in identifying if a deed in lieu is a feasible 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 amount of the debt. 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 house.

For a business transaction, the tax will be computed based upon the complete purchase price, which is expressly specified as consisting of the amount of liability which is assumed or to which the real estate is subject. Similarly, however much more potentially extreme, New York bases the amount of the transfer tax on "factor to consider," which is specified as the overdue balance of the debt, plus the overall quantity of any other making it through 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 amounts paid). Remembering the lending institution will, in a lot of jurisdictions, have to pay this tax again when eventually offering the residential or commercial property, the specific jurisdiction's rules on transfer tax can be a determinative element in deciding whether a deed-in-lieu deal is a feasible choice.

Bankruptcy Issues

A significant issue for loan providers when determining if a deed in lieu is a viable alternative is the concern that if the borrower becomes a debtor in an insolvency case after the deed in lieu is total, the personal bankruptcy court can cause the transfer to be unwound or reserved. Because a deed-in-lieu deal is a 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 customer was insolvent (or the transfer rendered the customer insolvent) and within the 90-day period set forth in the Bankruptcy Code, the borrower becomes a debtor in a personal 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 made for "less than a reasonably comparable value" and if the transferor was insolvent at the time of the transfer, became insolvent since of the transfer, was taken part in a service that preserved an unreasonably low level of capital or planned to incur debts beyond its ability to pay. In order to reduce against these threats, a loan provider needs to thoroughly examine and examine the customer's monetary condition and liabilities and, ideally, need audited financial declarations to validate the solvency status of the borrower. Moreover, the deed-in-lieu arrangement needs to include representations as to solvency and a covenant from the borrower not to apply for bankruptcy during the choice period.

This is yet another reason it is vital for a lending institution to acquire an appraisal to verify the value of the residential or commercial property in relation to the financial obligation. A present appraisal will assist the lending institution refute any accusations that the transfer was made for less than reasonably equivalent worth.

Title Insurance

As part of the initial acquisition of a real residential or commercial property, many owners and their lenders will get policies of title insurance coverage to protect their respective interests. A lender considering taking title to a residential or commercial property by virtue of a deed in lieu might ask whether it can depend on its loan provider's policy when it ends up being 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 very same entity that is the called insured under the lending institution's policy.

Since many loan providers choose to have title vested in a separate affiliate entity, in order to ensure continued protection under the lending institution's policy, the named lender must assign the mortgage to the designated affiliate victor prior to, or all at once with, the transfer of the charge. In the option, the lender can take title and then communicate the residential or commercial property by deed for no consideration to either its parent company or an entirely owned subsidiary (although in some jurisdictions this might set off transfer tax liability).

Notwithstanding the continuation in coverage, a lending institution's policy does not transform 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 supply the exact same or an appropriate level of protection. Moreover, a lending institution's policy does not avail any defense for matters which occur after the date of the mortgage loan, leaving the loan provider exposed to any concerns or claims coming from events which happen after the original closing.

Due to the reality deed-in-lieu deals are more prone to challenge and threats as laid out above, any title insurance provider issuing an owner's policy is likely to undertake a more strenuous evaluation of the deal throughout the underwriting process 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 identify and mitigate threats presented by issues such as merger, clogging, recharacterization and insolvency, thus potentially increasing the time and expenses included in closing the deal, but eventually providing the loan provider with a higher level of defense than the lender would have absent the title company's involvement.
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Ultimately, whether a deed-in-lieu transaction is a viable option for a lender is driven by the specific realities and scenarios of not only the loan and the residential or commercial property, but the celebrations involved as well. Under the right set of scenarios, and so long as the appropriate due diligence and paperwork is obtained, a deed in lieu can provide the loan provider with a more efficient and less costly means to recognize on its security when a loan enters into default.

Harris Beach Murtha's Commercial Realty Practice Group is experienced with deed in lieu of foreclosures. If you require assistance with such matters, please reach out to attorney Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach attorney with whom you most regularly work.