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When a business mortgage lender sets out to implement a mortgage loan following a debtor default, an essential objective is to determine the most expeditious way in which the lending institution can obtain control and ownership of the underlying security. Under the right set of scenarios, a deed in lieu of foreclosure can be a much faster and more cost-effective option to the long and drawn-out foreclosure process. This article discusses actions and concerns lenders must consider when deciding to continue with a deed in lieu of foreclosure and how to avoid unforeseen threats and challenges during and following the deed-in-lieu procedure.
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Consideration

A crucial element of any contract is ensuring there is appropriate factor to consider. In a standard deal, consideration can quickly be developed through the purchase rate, however in a deed-in-lieu situation, verifying adequate factor to consider is not as straightforward.

In a deed-in-lieu circumstance, the amount of the underlying debt that is being forgiven by the loan provider normally is the basis for the consideration, and in order for such consideration to be deemed "sufficient," the debt should at least equivalent or go beyond the reasonable market value of the subject residential or commercial property. It is crucial that lending institutions acquire an independent third-party appraisal to corroborate the value 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 borrower's express acknowledgement of the fair market price of the residential or commercial property in relation to the amount of the financial obligation and a waiver of any prospective claims related to the adequacy of the factor to consider.

Clogging and Recharacterization Issues

Clogging is shorthand for a primary rooted in ancient English typical law that a debtor who protects a loan with a mortgage on realty holds an unqualified right to redeem that residential or commercial property from the loan provider by repaying the financial obligation up until the point when the right of redemption is legally snuffed out through an appropriate foreclosure. Preserving the borrower's fair right of redemption is the reason, prior to default, mortgage loans can not be structured to ponder the voluntary transfer of the residential or commercial property to the loan provider.

Deed-in-lieu transactions prevent a borrower's equitable right of redemption, however, actions can be required to structure them to limit or avoid the threat of a blocking challenge. Primarily, the reflection 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 files. Parties ought to likewise watch out for a deed-in-lieu plan where, following the transfer, there is a continuation 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, an occupant or through repurchase alternatives, as any of these arrangements can create a threat of the deal being recharacterized as a fair mortgage.

Steps can be required to mitigate against recharacterization dangers. Some examples: if a customer's residential or commercial property management functions are limited to ministerial functions rather than substantive choice making, if a lease-back is short term and the payments are plainly structured as market-rate use and occupancy payments, or if any provision for reacquisition of the residential or commercial property by the borrower is established to be completely independent of the condition for the deed in lieu.

While not determinative, it is advised that deed-in-lieu arrangements 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 purposes only.

Merger of Title

When a loan provider makes a loan secured by a mortgage on genuine 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 lending institution then gets the property from a defaulting mortgagor, it now also holds an interest in the residential or commercial property by virtue of being the fee owner and getting the mortgagor's equity of redemption.

The general rule on this concern provides that, where a mortgagee gets 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 fee takes place 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 agreement plainly reflects the celebrations' intent to maintain the mortgage lien estate as unique from the charge so the lender retains the capability to foreclose the underlying mortgage if there are intervening liens. If the estates merge, then the lending institution's mortgage lien is snuffed out and the lender loses the ability to deal with intervening liens by foreclosure, which might leave the lender in a potentially worse position than if the lender pursued a foreclosure from the beginning.

In order to clearly reflect 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 debt, it is popular in a deed-in-lieu situation for the lending institution to deliver a covenant not to sue, rather than a straight-forward release of the debt. The covenant not to take legal action against furnishes consideration for the deed in lieu, safeguards the customer versus exposure from the debt and likewise keeps the lien of the mortgage, therefore allowing the loan provider to maintain the ability to foreclose, needs to it become desirable to remove junior encumbrances after the deed in lieu is total.

Transfer Tax

Depending upon the jurisdiction, dealing with 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 ends up taking in the cost considering that the debtor remains in a default circumstance and generally does not have funds.

How transfer tax is calculated on a deed-in-lieu transaction depends on the jurisdiction and can be a driving force in determining if a deed in lieu is a feasible 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 approximately the quantity of the financial obligation. Some other states, including Washington and Illinois, have uncomplicated exemptions for deed-in-lieu deals. In Connecticut, nevertheless, while there is an exemption for deed-in-lieu deals it is restricted only to a transfer of the borrower's personal house.

For an industrial transaction, the tax will be determined based on the complete purchase rate, which is expressly defined as consisting of the amount of liability which is assumed or to which the real estate is subject. Similarly, but even more potentially drastic, New york city bases the amount of the transfer tax on "consideration," which is specified as the unpaid balance of the debt, plus the total quantity of any other making it through liens and any amounts paid by the grantee (although if the loan is fully recourse, the factor to consider is capped at the fair market price of the residential or commercial property plus other quantities paid). Bearing in mind the lending institution will, in a lot of jurisdictions, have to pay this tax once again when eventually 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 option.

Bankruptcy Issues

A significant concern for loan providers when figuring out if a deed in lieu is a feasible option is the issue that if the borrower ends up being a debtor in an insolvency case after the deed in lieu is total, the bankruptcy court can trigger the transfer to be unwound or set aside. Because a deed-in-lieu transaction is a transfer made on, or account of, an antecedent debt, 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 customer insolvent) and within the 90-day period stated in the Bankruptcy Code, the borrower becomes a debtor in a 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 an insolvency filing and the transfer was produced "less than a fairly equivalent value" and if the transferor was insolvent at the time of the transfer, ended up being insolvent because of the transfer, was engaged in a business that maintained an unreasonably low level of capital or meant to sustain financial obligations beyond its capability to pay. In order to mitigate against these dangers, a loan provider ought to thoroughly review and examine the customer's financial condition and liabilities and, preferably, need audited monetary declarations to confirm the solvency status of the customer. Moreover, the deed-in-lieu agreement should consist of representations as to solvency and a covenant from the customer not to declare personal bankruptcy during the choice duration.

This is yet another reason why it is vital for a lending institution to procure an appraisal to verify the worth of the residential or commercial property in relation to the financial obligation. A current appraisal will assist the lending institution refute any accusations that the transfer was made for less than reasonably equivalent worth.

Title Insurance

As part of the initial acquisition of a genuine residential or commercial property, a lot of owners and their lending institutions will obtain policies of title insurance coverage to safeguard their respective 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 lender's policy of title insurance coverage can continue after the acquisition of title if title is taken by the exact same entity that is the named insured under the lending institution's policy.

Since many loan providers choose to have actually title vested in a separate affiliate entity, in order to make sure ongoing protection under the lender's policy, the called lender ought to assign the mortgage to the intended affiliate title holder prior to, or at the same time with, the transfer of the charge. In the alternative, the lending institution can take title and then communicate the residential or commercial property by deed for no factor to consider to either its parent business or an entirely owned subsidiary (although in some jurisdictions this might activate transfer tax liability).

Notwithstanding the continuation in coverage, a lending institution's policy does not convert 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 lender's policy would not provide the very same or an appropriate level of protection. Moreover, a lender's policy does not get any protection for matters which develop after the date of the mortgage loan, leaving the lender exposed to any concerns or claims coming from events which happen after the original closing.

Due to the truth deed-in-lieu transactions are more susceptible to challenge and dangers as detailed above, any title insurance company releasing an owner's policy is likely to carry out a more extensive evaluation of the transaction during the underwriting procedure than they would in a normal third-party purchase and sale transaction. The title insurer will scrutinize the celebrations and the deed-in-lieu files in order to determine and reduce threats provided by concerns such as merger, obstructing, recharacterization and insolvency, thus possibly increasing the time and costs involved in closing the deal, however eventually supplying the lender with a greater level of protection than the lender would have missing the title business's involvement.

Ultimately, whether a deed-in-lieu transaction is a feasible choice for a lender is driven by the specific truths and circumstances of not just the loan and the residential or commercial property, but the celebrations involved as well. Under the right set of circumstances, and so long as the appropriate due diligence and documents is gotten, a deed in lieu can offer the lender with a more effective and less expensive means to understand on its security 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 reach out to lawyer Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach attorney with whom you most frequently work.