When a commercial mortgage lender sets out to enforce a mortgage loan following a debtor default, a key objective is to recognize the most expeditious manner in which the lender can obtain control and ownership of the underlying collateral. Under the right set of situations, a deed in lieu of foreclosure can be a much faster and more affordable alternative to the long and lengthy foreclosure process. This short article discusses actions and issues loan providers ought to consider when deciding to proceed with a deed in lieu of foreclosure and how to prevent unanticipated threats and difficulties during and following the deed-in-lieu process.

Consideration

A crucial element of any agreement is ensuring there is appropriate consideration. In a basic deal, factor to consider can quickly be established through the purchase rate, however in a deed-in-lieu scenario, confirming adequate factor to consider is not as uncomplicated.

In a deed-in-lieu situation, the amount of the underlying debt that is being forgiven by the lending institution generally is the basis for the consideration, and in order for such factor to consider to be considered "sufficient," the financial obligation should at least equal or exceed the fair market price of the subject residential or commercial property. It is vital that lenders get an independent third-party appraisal to substantiate the worth of the residential or commercial property in relation to the quantity of debt being forgiven. In addition, its recommended the deed-in-lieu arrangement consist of the debtor's express recognition of the fair market worth of the residential or commercial property in relation to the amount of the financial obligation and a waiver of any prospective claims connected to 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 financial obligation up until the point when the right of redemption is lawfully extinguished through a proper foreclosure. Preserving the debtor's equitable right of redemption is the reason that, 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 transactions preclude a borrower's equitable right of redemption, however, steps can be taken to structure them to restrict or avoid the danger of a clogging obstacle. Firstly, the consideration of the transfer of the residential or commercial property in lieu of a foreclosure must take location post-default and can not be pondered by the underlying loan files. Parties need to likewise 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 borrower retains 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 arrangements can produce a threat of the transaction being recharacterized as an equitable mortgage.

Steps can be taken to mitigate against recharacterization dangers. Some examples: if a borrower'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 clearly structured as market-rate usage and occupancy payments, or if any provision for reacquisition of the residential or commercial property by the customer is set up to be totally independent of the condition for the deed in lieu.

While not determinative, it is suggested that deed-in-lieu contracts consist of the celebrations' clear and unquestionable recognition that the transfer of the residential or commercial property is an outright conveyance and not a transfer of for security functions just.

Merger of Title

When a lending institution makes a loan protected by a mortgage on real estate, 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 obtains the property from a defaulting mortgagor, it now likewise 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 general guideline on this issue supplies that, where a mortgagee gets the charge 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 absence of evidence of a contrary objective. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is important the arrangement clearly shows the parties' intent to keep the mortgage lien estate as unique from the cost so the loan provider keeps the ability to foreclose the underlying mortgage if there are intervening liens. If the estates merge, then the lender's mortgage lien is snuffed out and the loan provider loses the ability to handle intervening liens by foreclosure, which might leave the lender in a potentially even worse position than if the lending institution pursued a foreclosure from the outset.

In order to plainly show the parties' intent on this point, the deed-in-lieu contract (and the deed itself) should consist of reveal anti-merger language. Moreover, due to the fact that there can be no mortgage without a financial obligation, it is customary in a deed-in-lieu situation for the lender 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, safeguards the borrower against exposure from the financial obligation and likewise retains the lien of the mortgage, therefore enabling the loan provider to preserve the ability to foreclose, needs to it become desirable to eliminate junior encumbrances after the deed in lieu is complete.

Transfer Tax

Depending upon the jurisdiction, handling transfer tax and the payment thereof in deed-in-lieu deals can be a substantial sticking point. While the majority of states make the payment of transfer tax a seller commitment, as a useful matter, the loan provider winds up taking in the cost since the borrower remains in a default situation and usually does not have funds.

How transfer tax is calculated on a deed-in-lieu transaction is dependent on the jurisdiction and can be a driving force in determining if a deed in lieu is a viable option. 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 up to the amount of the debt. Some other states, consisting of Washington and Illinois, have simple exemptions for deed-in-lieu transactions. In Connecticut, nevertheless, 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 business transaction, the tax will be calculated based on the full purchase rate, which is expressly specified as including the amount of liability which is presumed or to which the real estate is subject. Similarly, but even more possibly extreme, New York bases the quantity of the transfer tax on "consideration," which is defined as the unpaid balance of the debt, plus the overall amount of any other surviving liens and any quantities paid by the beneficiary (although if the loan is fully recourse, the factor to consider is topped at the reasonable market value of the residential or commercial property plus other quantities paid). Bearing in mind the loan provider will, in a lot of jurisdictions, need 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 consider choosing whether a deed-in-lieu deal is a possible alternative.

Bankruptcy Issues

A major concern for lenders when determining if a deed in lieu is a feasible alternative is the concern that if the debtor ends up being a debtor in a personal bankruptcy case after the deed in lieu is total, the insolvency 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 dealing with preferential transfers. Accordingly, if the transfer was made when the borrower was insolvent (or the transfer rendered the borrower insolvent) and within the 90-day period stated in the Bankruptcy Code, the customer ends up being a debtor in an insolvency case, then the deed in lieu is at threat 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 bankruptcy filing and the transfer was produced "less than a reasonably equivalent value" and if the transferor was insolvent at the time of the transfer, became insolvent because of the transfer, was engaged in an organization that maintained an unreasonably low level of capital or planned to sustain debts beyond its ability to pay. In order to alleviate against these threats, a loan provider ought to thoroughly examine and evaluate the debtor's financial condition and liabilities and, ideally, require audited financial declarations to validate the solvency status of the borrower. Moreover, the deed-in-lieu contract should include representations as to solvency and a covenant from the debtor not to apply for insolvency throughout the choice period.

This is yet another reason it is necessary for a lender to obtain an appraisal to confirm the worth of the residential or commercial property in relation to the financial obligation. A current will assist the lender refute any accusations that the transfer was produced less than fairly equivalent value.

Title Insurance

As part of the initial acquisition of a real residential or commercial property, the majority of owners and their loan providers will acquire policies of title insurance to secure their respective interests. A loan provider thinking about taking title to a residential or commercial property by virtue of a deed in lieu might ask whether it can rely on its loan provider's policy when it becomes the fee owner. Coverage under a loan provider's policy of title insurance coverage can continue after the acquisition of title if title is taken by the same entity that is the named guaranteed under the lender's policy.

Since lots of lending institutions prefer to have actually title vested in a separate affiliate entity, in order to guarantee continued coverage under the loan provider's policy, the named lender must assign the mortgage to the desired affiliate victor prior to, or at the same time with, the transfer of the fee. In the option, the loan provider can take title and then convey the residential or commercial property by deed for no factor to consider to either its moms and dad business or an entirely owned subsidiary (although in some jurisdictions this might set off transfer tax liability).

Notwithstanding the extension in protection, a lending institution's policy does not transform to an owner's policy. Once the loan provider 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 provide the same or an adequate level of defense. Moreover, a loan provider's policy does not avail any security for matters which occur after the date of the mortgage loan, leaving the loan provider exposed to any issues or claims stemming from events which take place after the initial closing.

Due to the fact deed-in-lieu deals are more prone to challenge and risks as described above, any title insurer issuing an owner's policy is most likely to undertake a more extensive review of the transaction throughout the underwriting procedure than they would in a common third-party purchase and sale transaction. The title insurer will scrutinize the celebrations and the deed-in-lieu documents in order to determine and alleviate dangers presented by concerns such as merger, blocking, recharacterization and insolvency, consequently possibly increasing the time and expenses associated with closing the deal, however eventually providing the loan provider with a higher level of protection than the lending institution would have missing the title company's involvement.
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Ultimately, whether a deed-in-lieu transaction is a feasible option for a lender is driven by the particular realities and circumstances of not only the loan and the residential or commercial property, however the celebrations included too. Under the right set of scenarios, therefore long as the appropriate due diligence and documents is acquired, a deed in lieu can supply the lending institution with a more efficient and less costly methods to recognize on its collateral when a loan goes 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 lawyer with whom you most frequently work.