When an industrial mortgage lender sets out to implement a mortgage loan following a borrower default, a crucial goal is to identify the most expeditious manner in which the lending institution can obtain control and possession of the underlying security. Under the right set of situations, a deed in lieu of foreclosure can be a faster and more affordable alternative to the long and lengthy foreclosure process. This article talks about actions and issues lenders ought to consider when making the decision to continue with a deed in lieu of foreclosure and how to risks and difficulties throughout and following the deed-in-lieu procedure.

Consideration

A crucial element of any contract is making sure there is sufficient consideration. In a basic transaction, factor to consider can quickly be established through the purchase rate, but in a deed-in-lieu scenario, confirming adequate factor to consider is not as straightforward.

In a deed-in-lieu situation, the amount of the underlying financial obligation that is being forgiven by the lending institution usually is the basis for the factor to consider, and in order for such factor to consider to be considered "adequate," the financial obligation should a minimum of equivalent or exceed the reasonable market value of the subject residential or commercial property. It is essential that lending institutions get an independent third-party appraisal to corroborate the worth of the residential or commercial property in relation to the amount of debt being forgiven. In addition, its suggested the deed-in-lieu contract consist of the customer's express acknowledgement of the fair market worth of the residential or commercial property in relation to the quantity of the financial obligation and a waiver of any potential claims related to the adequacy of the consideration.

Clogging and Recharacterization Issues

Clogging is shorthand for a primary rooted in ancient English common law that a customer 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 repaying the debt up till the point when the right of redemption is legally snuffed out 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 ponder the voluntary transfer of the residential or commercial property to the lender.

Deed-in-lieu transactions preclude a debtor's fair right of redemption, nevertheless, steps can be required to structure them to restrict or avoid the danger of an obstructing obstacle. Most importantly, 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 files. Parties should also 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 customer keeps rights to the residential or commercial property, either as a residential or commercial property manager, a tenant or through repurchase options, as any of these plans can produce a risk of the transaction being recharacterized as a fair 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 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 suggested that deed-in-lieu contracts 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 real estate, it holds an interest in the realty 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 likewise 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 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 fee happens in the lack of evidence of a contrary objective. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is essential the arrangement clearly reflects the parties' intent to maintain the mortgage lien estate as distinct from the charge so the lender keeps the capability to foreclose the underlying mortgage if there are intervening liens. If the estates merge, then the lending institution's mortgage lien is extinguished and the lender loses the ability to handle intervening liens by foreclosure, which might leave the loan provider in a potentially even worse position than if the lending institution pursued a foreclosure from the start.

In order to clearly reflect the parties' intent on this point, the deed-in-lieu arrangement (and the deed itself) ought to consist of express anti-merger language. Moreover, because there can be no mortgage without a debt, it is customary in a deed-in-lieu situation for the lending institution to deliver a covenant not to take legal action against, rather than a straight-forward release of the debt. The covenant not to take legal action against furnishes factor to consider for the deed in lieu, protects the debtor against direct exposure from the debt and likewise maintains the lien of the mortgage, therefore enabling the lending institution to maintain the ability to foreclose, must it end up being preferable to eliminate junior encumbrances after the deed in lieu is total.

Transfer Tax

Depending on the jurisdiction, handling transfer tax and the payment thereof in deed-in-lieu transactions can be a significant sticking point. While a lot of states make the payment of transfer tax a seller commitment, as a useful matter, the lending institution winds up absorbing the cost given that the borrower remains in a default circumstance and usually lacks funds.

How transfer tax is calculated on a deed-in-lieu transaction depends on the jurisdiction and can be a driving force in identifying if a deed in lieu is a practical option. In California, for example, a conveyance or transfer from the mortgagor to the mortgagee as an outcome of a foreclosure or a deed in lieu will be exempt up to the amount of the financial obligation. Some other states, consisting of Washington and Illinois, have simple exemptions for deed-in-lieu transactions. In Connecticut, however, while there is an exemption for deed-in-lieu deals it is limited just to a transfer of the debtor's individual home.

For a business transaction, the tax will be determined based on the full purchase cost, which is expressly defined as consisting of the quantity of liability which is assumed or to which the real estate is subject. Similarly, but much more potentially oppressive, New York bases the amount of the transfer tax on "factor to consider," which is specified as the unsettled balance of the debt, plus the total amount of any other enduring liens and any amounts paid by the beneficiary (although if the loan is completely option, the consideration is topped at the reasonable market price of the residential or commercial property plus other amounts paid). Keeping in mind the loan provider will, in most 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 element in choosing whether a deed-in-lieu transaction is a possible option.

Bankruptcy Issues

A major concern for lenders when figuring out if a deed in lieu is a practical option is the concern that if the borrower ends up being a debtor in an insolvency case after the deed in lieu is total, the personal 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 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 debtor was insolvent (or the transfer rendered the borrower insolvent) and within the 90-day duration set forth in the Bankruptcy Code, the debtor becomes a debtor in a 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 an insolvency 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 due to the fact that of the transfer, was taken part in a company that kept an unreasonably low level of capital or planned to sustain debts beyond its ability to pay. In order to mitigate against these dangers, a lender must thoroughly review and evaluate the borrower's monetary condition and liabilities and, preferably, require audited financial declarations to verify the solvency status of the customer. Moreover, the deed-in-lieu contract must consist of representations as to solvency and a covenant from the borrower not to declare bankruptcy throughout the choice duration.

This is yet another reason that it is necessary for a loan provider to obtain an appraisal to verify the worth of the residential or commercial property in relation to the debt. An existing appraisal will help the loan provider refute any allegations that the transfer was produced less than fairly equivalent value.

Title Insurance

As part of the preliminary acquisition of a real residential or commercial property, most owners and their lenders will acquire policies of title insurance to protect their particular interests. A loan provider considering taking title to a residential or commercial property by virtue of a deed in lieu may ask whether it can depend on its loan provider's policy when it ends up being the cost owner. Coverage under a lending institution'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 called insured under the lending institution's policy.

Since numerous loan providers prefer to have actually title vested in a separate affiliate entity, in order to ensure ongoing coverage under the lender's policy, the named loan provider ought to designate the mortgage to the intended affiliate victor prior to, or concurrently with, the transfer of the fee. In the alternative, the lending institution can take title and after that convey the residential or commercial property by deed for no consideration to either its moms and dad company or an entirely owned subsidiary (although in some jurisdictions this might activate transfer tax liability).

Notwithstanding the continuation in coverage, a loan provider's policy does not convert 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 exact same or a sufficient level of security. Moreover, a lender's policy does not avail any protection for matters which occur after the date of the mortgage loan, leaving the lending institution exposed to any problems or claims originating from occasions which happen after the initial closing.

Due to the reality deed-in-lieu deals are more vulnerable to challenge and risks as laid out above, any title insurance provider providing an owner's policy is likely to carry out a more extensive review of the deal during the underwriting process than they would in a normal third-party purchase and sale deal. The title insurer will inspect the parties and the deed-in-lieu files in order to determine and alleviate dangers presented by problems such as merger, blocking, recharacterization and insolvency, thereby possibly increasing the time and expenses involved in closing the deal, however eventually supplying the loan provider with a greater level of security than the lender would have missing the title company's participation.
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Ultimately, whether a deed-in-lieu transaction is a practical option for a lending institution is driven by the specific realities and scenarios of not only the loan and the residential or commercial property, but the celebrations involved too. Under the right set of situations, and so long as the proper due diligence and documents is gotten, a deed in lieu can offer the loan provider with a more efficient and cheaper methods to recognize on its security when a loan goes into default.

Harris Beach Murtha's Commercial Real Estate Practice Group is experienced with deed in lieu of foreclosures. If you need support with such matters, please reach out to attorney Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach attorney with whom you most often work.
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