When a commercial mortgage lending institution sets out to enforce a mortgage loan following a borrower default, a crucial goal is to determine the most expeditious manner in which the lending institution can acquire control and belongings of the underlying collateral. Under the right set of circumstances, a deed in lieu of foreclosure can be a quicker and more affordable option to the long and lengthy foreclosure procedure. This article discusses steps and problems lenders need to consider when making the decision to proceed with a deed in lieu of foreclosure and how to prevent unanticipated risks and obstacles throughout and following the deed-in-lieu process.
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Consideration
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A crucial aspect of any agreement is making sure there is adequate factor to consider. In a standard transaction, consideration can easily be developed through the purchase cost, however in a deed-in-lieu situation, validating appropriate consideration is not as uncomplicated.

In a deed-in-lieu circumstance, the quantity of the underlying debt that is being forgiven by the lending institution generally is the basis for the consideration, and in order for such consideration to be deemed "appropriate," the financial obligation should at least equivalent or surpass the fair market price of the subject residential or commercial property. It is essential that lending institutions obtain an independent third-party appraisal to corroborate the worth of the residential or commercial property in relation to the amount of financial obligation being forgiven. In addition, its recommended the deed-in-lieu agreement consist of the debtor's reveal recognition of the reasonable market value of the residential or commercial property in relation to the amount of the debt and a waiver of any prospective claims related to 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 protects a loan with a mortgage on property holds an unqualified right to redeem that residential or commercial property from the loan provider by paying back the financial obligation up until the point when the right of redemption is legally extinguished through a proper foreclosure. Preserving the borrower's equitable right of redemption is the reason why, 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 preclude a borrower's fair right of redemption, however, actions can be required to structure them to limit or prevent the risk of a clogging obstacle. Firstly, the contemplation 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 also watch out for a deed-in-lieu plan where, following the transfer, there is an extension of a debtor/creditor relationship, or which contemplate that the customer keeps rights to the residential or commercial property, either as a residential or commercial property supervisor, a tenant or through repurchase choices, as any of these arrangements can develop a threat of the transaction being recharacterized as an equitable mortgage.

Steps can be required 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 choice making, if a lease-back is brief 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 completely independent of the condition for the deed in lieu.

While not determinative, it is recommended that deed-in-lieu contracts consist of the parties' clear and unequivocal recognition 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 lending institution makes a loan protected by a mortgage on genuine estate, it holds an interest in the realty by virtue of being the mortgagee under a mortgage (or a beneficiary under a deed of trust). If the lender then acquires the property 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 basic guideline on this problem supplies that, where a mortgagee acquires the cost 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 proof of a contrary objective. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is crucial the contract clearly shows the celebrations' intent to maintain the mortgage lien estate as unique from the cost so the lender keeps the ability to foreclose the underlying mortgage if there are intervening liens. If the estates merge, then the lender's mortgage lien is extinguished and the lender loses the capability to handle stepping in liens by foreclosure, which could leave the lending institution in a possibly even worse position than if the loan provider pursued a foreclosure from the outset.

In order to plainly show the celebrations' intent on this point, the deed-in-lieu arrangement (and the deed itself) ought to consist of reveal anti-merger language. Moreover, since there can be no mortgage without a financial obligation, it is traditional in a deed-in-lieu scenario for the loan provider to provide a covenant not to take legal action against, rather than a straight-forward release of the debt. The covenant not to sue furnishes factor to consider for the deed in lieu, protects the borrower versus direct exposure from the financial obligation and likewise retains the lien of the mortgage, thus allowing the lender to preserve the ability to foreclose, needs to it end up being preferable to remove junior encumbrances after the deed in lieu is total.

Transfer Tax

Depending upon the jurisdiction, handling transfer tax and the payment thereof in deed-in-lieu transactions can be a considerable sticking point. While the majority of states make the payment of transfer tax a seller obligation, as a practical matter, the lending institution winds up absorbing the cost given that the customer remains in a default situation and usually lacks funds.

How transfer tax is determined on a deed-in-lieu deal depends on the jurisdiction and can be a driving force in figuring out if a deed in lieu is a feasible 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 financial obligation. Some other states, including Washington and Illinois, have straightforward exemptions for deed-in-lieu deals. In Connecticut, however, while there is an exemption for deed-in-lieu deals it is limited just to a transfer of the borrower's personal residence.

For a commercial transaction, the tax will be determined based on the full purchase rate, which is specifically specified as including the amount of liability which is assumed or to which the real estate is subject. Similarly, however much more possibly oppressive, New york city bases the quantity of the transfer tax on "consideration," which is specified as the unsettled balance of the financial obligation, plus the total amount of any other making it through liens and any quantities paid by the grantee (although if the loan is totally option, the factor to consider is capped at the reasonable market value of the residential or commercial property plus other amounts paid). Bearing in mind the loan provider will, in many jurisdictions, have to pay this tax once again when eventually offering the residential or commercial property, the particular jurisdiction's rules on transfer tax can be a determinative factor in choosing whether a deed-in-lieu transaction is a feasible choice.

Bankruptcy Issues

A major issue for lenders when figuring out if a deed in lieu is a feasible alternative is the concern that if the customer ends up being a debtor in an insolvency case after the deed in lieu is complete, 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 financial obligation, 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 customer insolvent) and within the 90-day duration set forth in the Bankruptcy Code, the debtor becomes a debtor in a personal bankruptcy case, then the deed in lieu is at threat 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, became insolvent because of the transfer, was engaged in a business that kept an unreasonably low level of capital or intended to incur debts beyond its ability to pay. In order to reduce versus these risks, a loan provider ought to carefully evaluate and evaluate the debtor's financial condition and liabilities and, ideally, require audited monetary statements to verify the solvency status of the debtor. Moreover, the deed-in-lieu contract ought to consist of representations as to solvency and a covenant from the customer not to submit for insolvency throughout the choice period.

This is yet another factor why it is vital for a loan provider to procure an appraisal to validate the worth of the residential or commercial property in relation to the debt. A current appraisal will help the loan provider refute any accusations that the transfer was produced less than reasonably equivalent value.

Title Insurance

As part of the initial acquisition of a real residential or commercial property, a lot of owners and their lenders will acquire policies of title insurance to secure their particular interests. A lender thinking about taking title to a residential or commercial property by virtue of a deed in lieu may ask whether it can rely on its lending institution's policy when it becomes the fee owner. Coverage under a loan provider'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 lending institution's policy.

Since lots of loan providers choose to have actually title vested in a different affiliate entity, in order to ensure ongoing protection under the lending institution's policy, the called lender ought to appoint the mortgage to the desired affiliate title holder prior to, or concurrently with, the transfer of the charge. In the alternative, the loan provider can take title and then convey the residential or commercial property by deed for no consideration to either its parent business or an entirely owned subsidiary (although in some jurisdictions this might set off liability).

Notwithstanding the extension in coverage, a loan provider's policy does not transform to an owner's policy. Once the lending institution 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 same or an adequate level of defense. Moreover, a lending institution's policy does not get any protection for matters which arise after the date of the mortgage loan, leaving the loan provider exposed to any issues or claims stemming from events which happen after the original closing.

Due to the fact deed-in-lieu transactions are more susceptible to challenge and dangers as outlined above, any title insurance provider issuing an owner's policy is most likely to carry out a more rigorous evaluation of the deal throughout the underwriting process than they would in a typical third-party purchase and sale transaction. The title insurer will scrutinize the parties and the deed-in-lieu files in order to identify and reduce threats provided by issues such as merger, blocking, recharacterization and insolvency, therefore potentially increasing the time and costs associated with closing the deal, but eventually providing the lending institution with a higher level of security than the loan provider would have missing the title business's participation.

Ultimately, whether a deed-in-lieu deal is a viable choice for a loan provider is driven by the particular truths and circumstances of not only the loan and the residential or commercial property, however the celebrations involved as well. Under the right set of circumstances, and so long as the correct due diligence and paperwork is gotten, a deed in lieu can supply the lending institution with a more efficient and cheaper means to realize on its collateral 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 connect to attorney Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach attorney with whom you most regularly work.