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When a business mortgage loan provider sets out to impose a mortgage loan following a customer default, an essential objective is to identify the most expeditious way in which the lender can obtain control and possession of the underlying collateral. Under the right set of situations, a deed in lieu of foreclosure can be a faster and more economical alternative to the long and protracted foreclosure process. This article discusses actions and issues lenders ought to think about when deciding to continue with a deed in lieu of foreclosure and how to avoid unexpected risks and obstacles during and following the deed-in-lieu procedure.
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Consideration

A crucial element of any agreement is ensuring there is adequate factor to consider. In a standard deal, factor to consider can quickly be established through the purchase price, but in a deed-in-lieu circumstance, verifying sufficient consideration is not as straightforward.

In a deed-in-lieu situation, the quantity of the underlying debt that is being forgiven by the lender typically is the basis for the consideration, and in order for such consideration to be considered "adequate," the debt ought to a minimum of equivalent or exceed the reasonable market worth of the subject residential or commercial property. It is vital that lenders acquire an independent third-party appraisal to validate 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 consist of the borrower's reveal acknowledgement of the reasonable market price of the residential or commercial property in relation to the quantity of the financial obligation and a waiver of any possible 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 debtor who secures a loan with a mortgage on real estate holds an unqualified right to redeem that residential or commercial property from the lending institution by paying back the financial obligation up till the point when the right of redemption is lawfully snuffed out through a proper foreclosure. Preserving the borrower's fair right of redemption is the reason why, prior to default, mortgage loans can not be structured to consider the voluntary transfer of the residential or commercial property to the lending institution.

Deed-in-lieu transactions prevent a customer's fair right of redemption, however, actions can be required to structure them to limit or avoid the danger of an obstructing difficulty. First and foremost, the consideration of the transfer of the residential or commercial property in lieu of a foreclosure should happen post-default and can not be considered by the underlying loan documents. Parties should likewise watch out for a deed-in-lieu plan where, following the transfer, there is an extension of a debtor/creditor relationship, or which consider that the borrower retains rights to the residential or commercial property, either as a residential or commercial property supervisor, a renter or through repurchase options, as any of these arrangements can create a threat of the transaction being recharacterized as an equitable mortgage.

Steps can be taken to mitigate versus 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 usage and occupancy payments, or if any arrangement for reacquisition of the residential or commercial property by the debtor is set up to be totally independent of the condition for the deed in lieu.

While not determinative, it is recommended that deed-in-lieu agreements include the parties' 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 loan provider makes a loan secured by a mortgage on real estate, 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 loan provider then obtains the realty from a defaulting mortgagor, it now likewise holds an interest in the residential or commercial property by virtue of being the cost owner and obtaining the mortgagor's equity of redemption.

The general rule on this issue supplies that, where a mortgagee obtains 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 cost occurs in the absence of evidence of a contrary intent. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is necessary the agreement plainly shows the celebrations' intent to keep the mortgage lien estate as unique from the fee so the lender maintains the ability to foreclose the hidden mortgage if there are intervening liens. If the estates merge, then the loan provider's mortgage lien is extinguished and the lending institution loses the capability to handle stepping in liens by foreclosure, which might leave the lender in a potentially worse position than if the loan provider pursued a foreclosure from the beginning.

In order to clearly show the parties' intent on this point, the deed-in-lieu contract (and the deed itself) need to include express anti-merger language. Moreover, since there can be no mortgage without a financial obligation, it is popular in a deed-in-lieu scenario for the lender to provide a covenant not to take legal action against, instead of a straight-forward release of the financial obligation. The covenant not to take legal action against furnishes consideration for the deed in lieu, secures the customer against exposure from the debt and also retains the lien of the mortgage, thereby enabling the loan provider to the capability to foreclose, needs to it become desirable to remove 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 transactions can be a substantial sticking point. While most states make the payment of transfer tax a seller responsibility, as a useful matter, the lending institution ends up absorbing the cost given that the customer remains in a default circumstance 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 determining if a deed in lieu is a viable option. In California, for example, 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 quantity of the debt. Some other states, consisting of Washington and Illinois, have straightforward exemptions for deed-in-lieu deals. In Connecticut, nevertheless, while there is an exemption for deed-in-lieu transactions it is restricted just to a transfer of the customer's individual home.

For an industrial deal, the tax will be computed based upon the full purchase price, which is expressly defined as including the quantity of liability which is assumed or to which the real estate is subject. Similarly, however a lot more potentially exorbitant, 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 overall amount of any other enduring liens and any quantities paid by the grantee (although if the loan is completely recourse, the factor to consider is topped at the reasonable market value of the residential or commercial property plus other amounts paid). Keeping in mind the loan provider will, in the majority of jurisdictions, need to pay this tax once again when ultimately selling 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 deal is a possible option.

Bankruptcy Issues

A significant issue for loan providers when determining if a deed in lieu is a viable alternative is the issue that if the customer becomes a debtor in an insolvency case after the deed in lieu is total, the bankruptcy court can trigger the transfer to be unwound or reserved. Because a deed-in-lieu transaction 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 customer was insolvent (or the transfer rendered the borrower insolvent) and within the 90-day duration stated in the Bankruptcy Code, the customer becomes a debtor in a 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 fairly comparable value" and if the transferor was insolvent at the time of the transfer, became insolvent because of the transfer, was taken part in a service that kept an unreasonably low level of capital or planned to incur financial obligations beyond its capability to pay. In order to alleviate against these threats, a lending institution ought to carefully examine and examine the customer's monetary condition and liabilities and, preferably, require audited financial statements to validate the solvency status of the customer. Moreover, the deed-in-lieu arrangement must consist of representations regarding solvency and a covenant from the customer not to declare bankruptcy during the choice period.

This is yet another reason that it is imperative for a lender to acquire an appraisal to confirm the worth of the residential or commercial property in relation to the debt. A present appraisal will assist the loan provider refute any accusations that the transfer was made for less than reasonably comparable worth.

Title Insurance

As part of the initial acquisition of a genuine residential or commercial property, many owners and their loan providers will acquire policies of title insurance to secure 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 cost owner. Coverage under a lending institution's policy of title insurance can continue after the acquisition of title if title is taken by the same entity that is the called guaranteed under the lender's policy.

Since numerous lenders choose to have title vested in a different affiliate entity, in order to make sure ongoing protection under the lending institution's policy, the named loan provider ought to assign the mortgage to the designated affiliate victor prior to, or simultaneously with, the transfer of the cost. In the option, the loan provider can take title and after that convey the residential or commercial property by deed for no factor to consider to either its moms and dad business or a completely 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 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 provide the very same or an appropriate level of security. Moreover, a lending institution's policy does not obtain any security for matters which occur after the date of the mortgage loan, leaving the loan provider exposed to any problems or claims stemming from occasions which occur after the initial closing.

Due to the truth deed-in-lieu transactions are more susceptible to challenge and dangers as outlined above, any title insurer issuing an owner's policy is likely to undertake a more strenuous review of the deal throughout the underwriting process than they would in a common third-party purchase and sale deal. The title insurance company will scrutinize the parties and the deed-in-lieu files in order to recognize and alleviate risks provided by issues such as merger, blocking, recharacterization and insolvency, thereby possibly increasing the time and expenses involved in closing the deal, however eventually supplying the lender with a higher level of defense than the loan provider would have missing the title business's involvement.

Ultimately, whether a deed-in-lieu deal is a viable choice for a lender is driven by the particular facts and scenarios of not only the loan and the residential or commercial property, however the parties included too. Under the right set of scenarios, and so long as the proper due diligence and documents is obtained, a deed in lieu can offer the lending institution with a more efficient and more economical ways to understand 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 need help 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 regularly work.
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