When a business mortgage lending institution sets out to impose a mortgage loan following a debtor default, a key objective is to recognize the most expeditious manner in which the loan provider can obtain control and possession of the underlying collateral. Under the right set of scenarios, a deed in lieu of foreclosure can be a faster and more cost-effective option to the long and drawn-out foreclosure process. This article goes over actions and concerns loan providers must think about when deciding to proceed with a deed in lieu of foreclosure and how to prevent unanticipated risks and challenges during and following the deed-in-lieu process.

Consideration

A crucial element of any contract is ensuring there is sufficient consideration. In a standard transaction, consideration can quickly be established through the purchase price, but in a deed-in-lieu circumstance, confirming sufficient consideration is not as straightforward.
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In a deed-in-lieu scenario, the amount of the underlying financial obligation that is being forgiven by the lender usually is the basis for the factor to consider, and in order for such consideration to be deemed "appropriate," the financial obligation must a minimum of equal or go beyond the fair market price of the subject residential or commercial property. It is imperative that loan providers obtain an independent third-party appraisal to substantiate the worth 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 debtor's reveal recognition of the reasonable market value of the residential or commercial property in relation to the quantity of the financial obligation and a waiver of any prospective claims associated with the adequacy of the consideration.

Clogging and Recharacterization Issues

Clogging is shorthand for a principal rooted in ancient English common law that a borrower who secures a loan with a mortgage on realty holds an unqualified right to redeem that residential or commercial property from the lending institution by repaying the financial obligation up till the point when the right of redemption is legally snuffed out through a proper foreclosure. Preserving the debtor'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 transactions prevent a borrower's fair right of redemption, nevertheless, actions can be required to structure them to restrict or prevent the danger of a blocking challenge. Most importantly, the reflection of the transfer of the residential or commercial property in lieu of a foreclosure should occur post-default and can not be contemplated by the underlying loan files. Parties must likewise be cautious of a deed-in-lieu arrangement where, following the transfer, there is a continuation of a debtor/creditor relationship, or which consider that the customer retains rights to the residential or commercial property, either as a residential or commercial property manager, a renter or through repurchase choices, as any of these plans can create a threat of the transaction being recharacterized as an equitable mortgage.

Steps can be taken to reduce against recharacterization threats. Some examples: if a debtor's residential or commercial property management functions are restricted to ministerial functions instead of substantive choice making, if a lease-back is brief term and the payments are plainly structured as market-rate usage and tenancy payments, or if any arrangement for reacquisition of the residential or commercial property by the customer is established to be entirely independent of the condition for the deed in lieu.

While not determinative, it is suggested that deed-in-lieu arrangements include the celebrations' clear and unequivocal recognition that the transfer of the residential or commercial property is an absolute conveyance and not a transfer of for security functions only.

Merger of Title

When a lender makes a loan protected by a mortgage on genuine estate, it holds an interest in the genuine estate by virtue of being the mortgagee under a mortgage (or a beneficiary under a deed of trust). If the lender then acquires 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 acquiring the mortgagor's equity of redemption.

The basic guideline on this problem offers 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 charge occurs in the lack of evidence of a contrary intent. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is very important the agreement plainly reflects the parties' intent to retain the mortgage lien estate as unique from the fee so the lender retains the ability to foreclose the underlying mortgage if there are stepping in liens. If the estates combine, then the lender's mortgage lien is snuffed out and the lender loses the to deal with intervening liens by foreclosure, which might leave the lending institution in a possibly even worse position than if the lending institution pursued a foreclosure from the start.

In order to plainly reflect the parties' intent on this point, the deed-in-lieu agreement (and the deed itself) ought to consist of express anti-merger language. Moreover, due to the fact that there can be no mortgage without a debt, it is traditional 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 financial obligation. The covenant not to sue furnishes factor to consider for the deed in lieu, protects the borrower against exposure from the financial obligation and also retains the lien of the mortgage, thereby permitting the lending institution to maintain the ability to foreclose, should it end up being preferable 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 significant sticking point. While a lot of states make the payment of transfer tax a seller commitment, as a practical matter, the loan provider winds up taking in the cost since the debtor is in a default scenario and typically does not have funds.

How transfer tax is computed on a deed-in-lieu deal depends on the jurisdiction and can be a driving force in determining if a deed in lieu is a viable alternative. In California, for instance, a conveyance or transfer from the mortgagor to the mortgagee as an outcome of a foreclosure or a deed in lieu will be exempt approximately the quantity of the debt. Some other states, consisting of Washington and Illinois, have simple exemptions for deed-in-lieu deals. In Connecticut, nevertheless, while there is an exemption for deed-in-lieu transactions it is restricted only to a transfer of the debtor's personal residence.

For a business transaction, the tax will be determined based on 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, but even more potentially severe, New york city bases the quantity of the transfer tax on "factor to consider," which is specified as the unsettled balance of the financial obligation, plus the total amount of any other surviving liens and any amounts paid by the beneficiary (although if the loan is fully recourse, the consideration is topped at the reasonable market worth of the residential or commercial property plus other quantities paid). Remembering the loan provider will, in the majority of jurisdictions, have 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 factor in choosing whether a deed-in-lieu transaction is a practical choice.

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 borrower becomes a debtor in a personal bankruptcy case after the deed in lieu is complete, the 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 directly 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 debtor insolvent) and within the 90-day duration set forth in the Bankruptcy Code, the debtor ends up being 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 set aside if it is made within one year prior to a personal 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, ended up being insolvent since of the transfer, was taken part in an organization that maintained an unreasonably low level of capital or intended to sustain financial obligations beyond its ability to pay. In order to mitigate versus these dangers, a loan provider should thoroughly evaluate and assess the borrower's monetary condition and liabilities and, ideally, need audited financial statements to validate the solvency status of the debtor. Moreover, the deed-in-lieu contract should consist of representations as to solvency and a covenant from the customer not to apply for personal bankruptcy throughout the preference period.

This is yet another reason it is necessary for a lending institution to procure an appraisal to verify the worth of the residential or commercial property in relation to the debt. A present appraisal will assist the loan provider refute any allegations that the transfer was made for less than reasonably comparable value.

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 safeguard their particular interests. A lender thinking about 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 becomes the charge owner. Coverage under a lender'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 insured under the loan provider's policy.

Since numerous lenders prefer to have title vested in a separate affiliate entity, in order to ensure continued coverage under the loan provider's policy, the named lender must assign the mortgage to the desired affiliate victor prior to, or all at once with, the transfer of the charge. In the alternative, the lender can take title and then communicate the residential or commercial property by deed for no factor to consider to either its parent company or an entirely owned subsidiary (although in some jurisdictions this could set off transfer tax liability).

Notwithstanding the extension in protection, a loan provider's policy does not convert 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 lending institution's policy would not offer the very same or an adequate level of defense. Moreover, a lender's policy does not obtain any security for matters which occur after the date of the mortgage loan, leaving the lender exposed to any concerns or claims coming from occasions which take place after the original closing.

Due to the reality deed-in-lieu transactions are more susceptible to challenge and dangers as described above, any title insurer providing an owner's policy is likely to carry out a more rigorous evaluation of the deal throughout the underwriting procedure than they would in a common third-party purchase and sale transaction. The title insurer will inspect the celebrations and the deed-in-lieu files in order to recognize and alleviate dangers provided by problems such as merger, clogging, recharacterization and insolvency, consequently possibly increasing the time and costs involved in closing the transaction, but ultimately offering the lending institution with a higher level of security than the lender would have missing the title company's participation.
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Ultimately, whether a deed-in-lieu transaction is a feasible alternative for a lending institution is driven by the specific facts and situations of not just the loan and the residential or commercial property, but the parties involved too. Under the right set of scenarios, therefore long as the correct due diligence and paperwork is acquired, a deed in lieu can provide the lender with a more effective and less costly methods to recognize 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 connect to attorney Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach lawyer with whom you most frequently work.