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When an industrial mortgage loan provider sets out to enforce a mortgage loan following a customer default, a key objective is to identify the most expeditious way in which the lending institution can obtain control and ownership of the underlying collateral. Under the right set of scenarios, a deed in lieu of foreclosure can be a quicker and more affordable option to the long and lengthy foreclosure procedure. This article discusses steps and problems lenders ought to consider when making the choice to continue with a deed in lieu of foreclosure and how to prevent unforeseen dangers and challenges throughout and following the deed-in-lieu process.

Consideration
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A crucial element of any contract is ensuring there is appropriate factor to consider. In a basic transaction, factor to consider can quickly be established through the purchase cost, but in a deed-in-lieu situation, confirming adequate factor to consider is not as uncomplicated.

In a deed-in-lieu circumstance, the amount of the underlying financial obligation that is being forgiven by the lending institution typically is the basis for the factor to consider, and in order for such consideration to be considered "appropriate," the financial obligation ought to a minimum of equivalent or exceed the reasonable market price of the subject residential or commercial property. It is important that lenders acquire 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 suggested the deed-in-lieu arrangement include the borrower's express acknowledgement of the reasonable market worth of the residential or commercial property in relation to the quantity of the debt and a waiver of any prospective claims related to the adequacy of the consideration.

Clogging and Recharacterization Issues

Clogging is shorthand for a primary rooted in ancient English typical 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 financial obligation up till the point when the right of redemption is lawfully snuffed out through a proper foreclosure. Preserving the customer's fair right of redemption is the factor why, prior to default, mortgage loans can not be structured to contemplate the voluntary transfer of the residential or commercial property to the loan provider.

Deed-in-lieu deals prevent a borrower's equitable right of redemption, however, actions can be required to structure them to limit or the threat of an obstructing challenge. Primarily, the consideration 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 watch out for a deed-in-lieu plan where, following the transfer, there is an extension of a debtor/creditor relationship, or which contemplate that the customer retains rights to the residential or commercial property, either as a residential or commercial property manager, a renter or through repurchase alternatives, as any of these plans can produce a threat of the transaction being recharacterized as an equitable mortgage.

Steps can be taken to mitigate versus recharacterization threats. Some examples: if a customer's residential or commercial property management functions are limited to ministerial functions rather than substantive decision making, if a lease-back is brief term and the payments are plainly structured as market-rate use and occupancy payments, or if any arrangement for reacquisition of the residential or commercial property by the borrower is established 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 indisputable acknowledgement that the transfer of the residential or commercial property is an outright conveyance and not a transfer of for security purposes just.

Merger of Title

When a lender makes a loan protected by a mortgage on realty, it holds an interest in the realty by virtue of being the mortgagee under a mortgage (or a beneficiary under a deed of trust). If the loan provider then acquires the genuine estate from a defaulting mortgagor, it now also holds an interest in the residential or commercial property by virtue of being the charge owner and obtaining the mortgagor's equity of redemption.

The general rule on this concern offers 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 cost occurs in the absence of proof of a contrary intent. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is very important the arrangement plainly shows the celebrations' intent to maintain the mortgage lien estate as distinct from the charge so the loan provider retains the capability to foreclose the hidden mortgage if there are intervening liens. If the estates merge, then the lending institution's mortgage lien is extinguished and the loan provider loses the ability to deal with intervening liens by foreclosure, which could leave the loan provider in a potentially worse position than if the lending institution pursued a foreclosure from the beginning.

In order to clearly show the celebrations' intent on this point, the deed-in-lieu contract (and the deed itself) must include reveal anti-merger language. Moreover, since there can be no mortgage without a debt, it is traditional in a deed-in-lieu scenario for the lender to deliver a covenant not to sue, instead of a straight-forward release of the financial obligation. The covenant not to sue furnishes consideration for the deed in lieu, secures the debtor against exposure from the financial obligation and also maintains the lien of the mortgage, thereby allowing the lender to preserve the capability to foreclose, ought to it become desirable 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 deals can be a substantial sticking point. While a lot of states make the payment of transfer tax a seller obligation, as a practical matter, the lending institution ends up soaking up the expense given that the debtor remains in a default situation and normally lacks funds.

How transfer tax is determined 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 practical 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 uncomplicated exemptions for deed-in-lieu deals. In Connecticut, nevertheless, while there is an exemption for deed-in-lieu deals it is limited only to a transfer of the borrower's individual house.

For a business deal, the tax will be calculated based on the complete purchase price, which is expressly defined as including the amount of liability which is assumed or to which the real estate is subject. Similarly, however a lot more potentially heavy-handed, New york city bases the amount of the transfer tax on "factor to consider," which is defined as the unsettled balance of the financial obligation, plus the overall amount 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 topped at the reasonable market worth of the residential or commercial property plus other quantities paid). Bearing in mind the lender will, in a lot of jurisdictions, need to pay this tax once again when ultimately selling the residential or commercial property, the particular jurisdiction's rules on transfer tax can be a determinative factor in deciding whether a deed-in-lieu transaction is a possible option.

Bankruptcy Issues

A significant concern for loan providers when determining if a deed in lieu is a viable option is the concern that if the customer becomes a debtor in a bankruptcy case after the deed in lieu is complete, the bankruptcy 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 customer 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 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 made for "less than a reasonably comparable worth" and if the transferor was insolvent at the time of the transfer, ended up being insolvent since of the transfer, was participated in a service that kept an unreasonably low level of capital or meant to sustain debts beyond its ability to pay. In order to alleviate against these risks, a lending institution ought to thoroughly examine and examine the borrower's monetary condition and liabilities and, ideally, require audited financial statements to verify the solvency status of the customer. Moreover, the deed-in-lieu contract should include representations regarding solvency and a covenant from the borrower not to declare insolvency throughout the preference duration.

This is yet another reason it is important for a loan provider to acquire 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 claims that the transfer was made for less than fairly comparable worth.

Title Insurance

As part of the initial acquisition of a genuine residential or commercial property, most owners and their loan providers will obtain policies of title insurance coverage to safeguard their particular interests. A loan provider considering taking title to a residential or commercial property by virtue of a deed in lieu might ask whether it can rely on its lending institution's policy when it becomes the charge owner. Coverage under a loan provider's policy of title insurance can continue after the acquisition of title if title is taken by the exact same entity that is the called insured under the loan provider's policy.

Since numerous loan providers prefer to have actually title vested in a separate affiliate entity, in order to guarantee ongoing protection under the loan provider's policy, the named lending institution needs to appoint the mortgage to the desired affiliate title holder prior to, or at the same time with, the transfer of the fee. In the alternative, 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 company or an entirely owned subsidiary (although in some jurisdictions this might set off transfer tax liability).

Notwithstanding the continuation in protection, a loan provider's policy does not convert to an owner's policy. Once the lender 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 supply the same or a sufficient level of protection. Moreover, a lending institution's policy does not avail any security for matters which develop after the date of the mortgage loan, leaving the lending institution exposed to any problems or claims originating from events which occur after the original closing.

Due to the fact deed-in-lieu transactions are more susceptible to challenge and dangers as detailed above, any title insurance provider providing an owner's policy is likely to undertake a more strenuous review of the deal throughout the underwriting process than they would in a normal third-party purchase and sale transaction. The title insurance provider will scrutinize the parties and the deed-in-lieu documents in order to recognize and alleviate risks presented by problems such as merger, blocking, recharacterization and insolvency, thus possibly increasing the time and expenses included in closing the deal, however ultimately supplying the lender with a greater level of protection than the lending institution would have missing the title company's involvement.

Ultimately, whether a deed-in-lieu deal is a practical alternative for a lender is driven by the particular realities and scenarios of not just the loan and the residential or commercial property, but the parties included too. Under the right set of circumstances, and so long as the correct due diligence and documents is gotten, a deed in lieu can supply the lending institution with a more efficient and more economical methods to realize on its collateral 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 lawyer with whom you most regularly work.