When a business mortgage lending institution sets out to enforce a mortgage loan following a customer default, a key goal is to determine the most expeditious way in which the lender 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 economical option to the long and lengthy foreclosure process. This post goes over steps and concerns loan providers ought to think about when deciding to continue with a deed in lieu of foreclosure and how to avoid unforeseen risks and obstacles during and following the deed-in-lieu process.

Consideration

A crucial element of any contract is guaranteeing there is appropriate consideration. In a basic transaction, consideration can quickly be established through the purchase rate, however in a deed-in-lieu situation, confirming adequate factor to consider is not as straightforward.

In a deed-in-lieu scenario, the quantity of the underlying financial obligation that is being forgiven by the lending institution normally is the basis for the factor to consider, and in order for such consideration to be considered "adequate," the debt should at least equivalent or surpass the fair market price of the subject residential or commercial property. It is crucial that lending institutions obtain an independent third-party appraisal to corroborate the value of the residential or commercial property in relation to the amount of debt being forgiven. In addition, its recommended the deed-in-lieu contract include the debtor's express recognition of the fair market price 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 factor to consider.

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 realty holds an unqualified right to redeem that residential or commercial property from the lending institution by paying back the debt up until the point when the right of redemption is legally snuffed out through a correct foreclosure. Preserving the borrower's fair right of redemption is the reason, prior to default, mortgage loans can not be structured to consider the voluntary transfer of the residential or commercial property to the lender.

Deed-in-lieu deals prevent a borrower's equitable right of redemption, however, steps can be taken to structure them to restrict or prevent the risk of an obstructing challenge. Primarily, the reflection of the transfer of the residential or commercial property in lieu of a foreclosure need to happen post-default and can not be contemplated by the underlying loan documents. Parties should also be cautious of a deed-in-lieu arrangement where, following the transfer, there is a continuation of a debtor/creditor relationship, or which contemplate that the customer maintains rights to the residential or commercial property, either as a residential or commercial property manager, a renter or through repurchase options, as any of these plans can create a risk of the transaction being recharacterized as a fair mortgage.

Steps can be taken to alleviate versus recharacterization dangers. Some examples: if a customer's residential or commercial property management functions are restricted to ministerial functions rather than substantive decision making, if a lease-back is brief term and the payments are clearly structured as market-rate usage and occupancy payments, or if any arrangement for reacquisition of the residential or commercial property by the debtor is established to be totally independent of the condition for the deed in lieu.

While not determinative, it is recommended that deed-in-lieu arrangements consist of the celebrations' clear and indisputable acknowledgement 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 loan provider makes a loan protected by a mortgage on realty, 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 lender then obtains the genuine estate from a defaulting mortgagor, it now also holds an interest in the residential or commercial property by virtue of being the cost owner and getting the mortgagor's equity of redemption.

The basic rule on this issue supplies that, where a mortgagee gets 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 charge occurs in the lack of evidence of a contrary intent. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is very important the arrangement clearly shows the parties' intent to retain the mortgage lien estate as distinct from the charge so the lender maintains the capability to foreclose the underlying mortgage if there are intervening liens. If the estates merge, then the loan provider's mortgage lien is snuffed out and the lender loses the capability to deal with intervening liens by foreclosure, which could leave the loan provider in a possibly even worse position than if the lender pursued a foreclosure from the start.

In order to plainly reflect the celebrations' intent on this point, the deed-in-lieu contract (and the deed itself) need to include reveal anti-merger language. Moreover, due to the fact that there can be no mortgage without a debt, it is popular in a deed-in-lieu circumstance for the lender to provide a covenant not to sue, rather than a straight-forward release of the financial obligation. The covenant not to sue furnishes consideration for the deed in lieu, protects the borrower versus exposure from the financial obligation and likewise maintains the lien of the mortgage, thus allowing the lender to maintain the capability to foreclose, ought to it become desirable to eliminate junior encumbrances after the deed in lieu is complete.

Transfer Tax

Depending on the jurisdiction, dealing with transfer tax and the payment thereof in deed-in-lieu transactions can be a considerable sticking point. While most states make the payment of transfer tax a seller commitment, as a practical matter, the lending institution ends up soaking up the expense given that the debtor remains in a default situation and typically lacks funds.

How transfer tax is computed on a deed-in-lieu transaction is dependent on the jurisdiction and can be a driving force in identifying if a deed in lieu is a feasible 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 quantity of the debt. Some other states, including Washington and Illinois, have simple exemptions for deed-in-lieu deals. In Connecticut, however, while there is an exemption for deed-in-lieu deals it is restricted only to a transfer of the customer's individual home.

For a commercial deal, the tax will be calculated based upon the full purchase cost, which is expressly specified as including the quantity of liability which is presumed or to which the real estate is subject. Similarly, however even more possibly draconian, New York bases the amount of the transfer tax on "consideration," which is defined as the unsettled balance of the debt, plus the total amount of any other surviving liens and any amounts paid by the beneficiary (although if the loan is totally recourse, the consideration is capped at the reasonable market price of the residential or commercial property plus other amounts paid). Remembering the loan provider will, in the majority of jurisdictions, need to pay this tax again when ultimately offering the residential or commercial property, the specific jurisdiction's rules on transfer tax can be a determinative element in choosing whether a deed-in-lieu transaction is a practical choice.

Bankruptcy Issues

A major issue for loan providers when figuring out if a deed in lieu is a practical option is the concern that if the debtor becomes a debtor in an insolvency case after the deed in lieu is total, the insolvency court can cause 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 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 stated in the Bankruptcy Code, the debtor 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 personal bankruptcy filing and the transfer was produced "less than a reasonably equivalent worth" and if the transferor was insolvent at the time of the transfer, became insolvent because of the transfer, was engaged in a service that preserved an unreasonably low level of capital or meant to sustain debts beyond its ability to pay. In order to mitigate versus these risks, a loan provider should thoroughly examine and examine the customer's monetary condition and liabilities and, preferably, need audited monetary declarations to validate the solvency status of the borrower. Moreover, the deed-in-lieu agreement must include representations regarding solvency and a covenant from the debtor not to file for bankruptcy throughout the choice period.

This is yet another factor why it is imperative for a loan provider to obtain an appraisal to verify the value of the residential or commercial property in relation to the financial obligation. A present appraisal will assist the lender refute any accusations that the transfer was produced less than reasonably comparable worth.

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 safeguard their particular interests. A lender considering taking title to a residential or commercial property by virtue of a deed in lieu might ask whether it can count on its lender's policy when it ends up being the fee owner. Coverage under a lender's policy of title insurance can continue after the acquisition of title if title is taken by the same entity that is the named insured under the loan provider's policy.

Since numerous lenders prefer to have title vested in a separate affiliate entity, in order to make sure continued coverage under the lender's policy, the named lending institution needs to assign the mortgage to the designated affiliate title holder prior to, or simultaneously with, the transfer of the fee. In the option, the lending institution can take title and after that convey the residential or commercial property by deed for no consideration to either its parent company or a completely owned subsidiary (although in some jurisdictions this could trigger transfer tax liability).

Notwithstanding the extension in protection, a lender's policy does not transform to an owner's policy. Once the loan provider 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 exact same or an adequate level of protection. Moreover, a lender's policy does not get any security for matters which arise after the date of the mortgage loan, leaving the lender exposed to any issues or claims stemming from occasions which take place after the original closing.

Due to the truth deed-in-lieu transactions are more prone to challenge and threats as detailed above, any title insurance company releasing an owner's policy is likely to carry out a more strenuous review of the transaction during the underwriting process than they would in a common third-party purchase and sale transaction. The title insurance company will scrutinize the and the deed-in-lieu files in order to determine and mitigate dangers presented by issues such as merger, clogging, recharacterization and insolvency, thereby potentially increasing the time and costs involved in closing the transaction, however eventually supplying the loan provider with a greater level of security than the lending institution would have absent the title business's participation.
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Ultimately, whether a deed-in-lieu deal is a feasible choice for a loan provider is driven by the particular realities and scenarios of not only the loan and the residential or commercial property, but the parties included also. Under the right set of scenarios, therefore long as the correct due diligence and documentation is obtained, a deed in lieu can offer the lender with a more efficient and more economical ways to recognize on its security when a loan enters into default.

Harris Beach Murtha's Commercial Property Practice Group is experienced with deed in lieu of foreclosures. If you need assistance 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.