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When a commercial mortgage lending institution sets out to implement a mortgage loan following a borrower default, a key goal is to identify the most expeditious way in which the loan provider can obtain control and belongings of the underlying security. Under the right set of situations, a deed in lieu of foreclosure can be a faster and more economical option to the long and lengthy foreclosure procedure. This article discusses actions and problems lenders ought to consider when deciding to proceed with a deed in lieu of foreclosure and how to avoid unforeseen dangers and difficulties throughout and following the deed-in-lieu procedure.

Consideration

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

In a deed-in-lieu circumstance, the quantity of the underlying financial obligation that is being forgiven by the loan provider typically is the basis for the consideration, and in order for such consideration to be considered "appropriate," the financial obligation must a minimum of equal or surpass the reasonable market value of the subject residential or commercial property. It is crucial that lenders acquire an independent third-party appraisal to substantiate the value of the residential or commercial property in relation to the amount of debt being forgiven. In addition, its advised the deed-in-lieu agreement consist of the borrower's express recognition of the reasonable market worth of the residential or commercial property in relation to the quantity of the financial obligation and a waiver of any possible claims connected to the adequacy of the factor to consider.

Clogging and Recharacterization Issues

Clogging is shorthand for a principal 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 lender by repaying the financial obligation up till the point when the right of redemption is lawfully extinguished through a correct foreclosure. Preserving the debtor's fair right of redemption is the reason that, prior to default, mortgage loans can not be structured to contemplate the voluntary transfer of the residential or commercial property to the lender.

Deed-in-lieu deals prevent a customer's fair right of redemption, nevertheless, steps can be taken to structure them to restrict or avoid the risk of an obstructing challenge. Primarily, the contemplation of the transfer of the residential or commercial property in lieu of a foreclosure must occur 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 ponder that the customer maintains rights to the residential or commercial property, either as a residential or commercial property manager, an occupant or through repurchase choices, as any of these plans can develop a danger of the deal being recharacterized as an equitable mortgage.

Steps can be required to alleviate against recharacterization risks. Some examples: if a borrower's residential or commercial property management functions are limited to ministerial functions instead of substantive choice making, if a lease-back is short term and the payments are plainly structured as market-rate use and tenancy payments, or if any provision 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 recommended that deed-in-lieu arrangements include the celebrations' clear and unquestionable acknowledgement that the transfer of the residential or commercial property is an outright conveyance and not a transfer of for security functions only.

Merger of Title

When a loan provider makes a loan protected by a mortgage on property, it holds an interest in the property by virtue of being the mortgagee under a mortgage (or a beneficiary under a deed of trust). If the lender then obtains the realty 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 guideline on this issue offers 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 takes place in the lack of evidence of a contrary intention. Accordingly, when structuring and recording a deed in lieu of foreclosure, it is essential the arrangement clearly reflects the celebrations' intent to keep the mortgage lien estate as unique from the cost so the lending institution retains the to foreclose the hidden mortgage if there are stepping in liens. If the estates merge, then the lending institution's mortgage lien is extinguished and the loan provider loses the ability to handle intervening liens by foreclosure, which could leave the lending institution in a possibly 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 arrangement (and the deed itself) must consist of reveal anti-merger language. Moreover, because there can be no mortgage without a financial obligation, it is customary in a deed-in-lieu situation for the lending institution to deliver a covenant not to sue, instead of a straight-forward release of the financial obligation. The covenant not to take legal action against furnishes factor to consider for the deed in lieu, secures the debtor versus exposure from the financial obligation and also keeps the lien of the mortgage, therefore enabling the lender to preserve the ability to foreclose, ought to it end up being desirable to get rid of junior encumbrances after the deed in lieu is complete.

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 many states make the payment of transfer tax a seller responsibility, as a practical matter, the lending institution ends up soaking up the cost since the customer is in a default situation and typically lacks funds.

How transfer tax is computed on a deed-in-lieu transaction is reliant 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 amount of the debt. Some other states, consisting of Washington and Illinois, have straightforward 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 customer's personal residence.

For an industrial deal, the tax will be determined based upon the full purchase price, which is expressly defined as including the amount of liability which is assumed or to which the real estate is subject. Similarly, but much more potentially exorbitant, New York bases the amount of the transfer tax on "factor to consider," which is defined as the overdue balance of the financial obligation, plus the total quantity of any other surviving liens and any quantities paid by the beneficiary (although if the loan is fully recourse, the consideration is capped at the fair market price of the residential or commercial property plus other amounts paid). Remembering the loan provider will, in the majority of jurisdictions, have to pay this tax again when ultimately selling the residential or commercial property, the particular jurisdiction's guidelines on transfer tax can be a determinative consider deciding whether a deed-in-lieu transaction is a practical alternative.

Bankruptcy Issues

A major concern for lenders when figuring out if a deed in lieu is a practical alternative is the concern that if the borrower ends up being a debtor in a personal bankruptcy case after the deed in lieu is total, the insolvency court can cause 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 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 borrower insolvent) and within the 90-day period stated in the Bankruptcy Code, the borrower ends up being a debtor in an insolvency case, then the deed in lieu is at risk of being set aside.

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 made for "less than a fairly comparable value" and if the transferor was insolvent at the time of the transfer, ended up being insolvent due to the fact that of the transfer, was taken part in an organization that maintained an unreasonably low level of capital or planned to sustain financial obligations beyond its ability to pay. In order to alleviate against these threats, a loan provider needs to thoroughly review and evaluate the debtor's monetary condition and liabilities and, ideally, require audited monetary declarations to confirm the solvency status of the borrower. Moreover, the deed-in-lieu arrangement needs to include representations as to solvency and a covenant from the customer not to declare personal bankruptcy during the choice period.

This is yet another reason that it is necessary for a loan provider to obtain an appraisal to validate the worth of the residential or commercial property in relation to the financial obligation. An existing appraisal will assist the lender refute any claims that the transfer was produced less than fairly equivalent value.

Title Insurance

As part of the initial acquisition of a genuine residential or commercial property, the majority of owners and their lenders will obtain policies of title insurance to protect their respective 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 becomes the fee owner. Coverage under a lending institution'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 guaranteed under the loan provider's policy.

Since lots of lending institutions choose to have title vested in a separate affiliate entity, in order to ensure continued protection under the lending institution's policy, the named lender must appoint the mortgage to the desired affiliate victor prior to, or simultaneously with, the transfer of the fee. In the alternative, the lender can take title and after that convey the residential or commercial property by deed for no consideration to either its parent business or an entirely owned subsidiary (although in some jurisdictions this might set off transfer tax liability).

Notwithstanding the continuation in coverage, a lender's policy does not convert to an owner's policy. Once the lending institution ends up being an owner, the nature and scope of the claims that would be made under a policy are such that the loan provider's policy would not offer the exact same or an appropriate level of security. Moreover, a lending institution'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 concerns or claims originating from events which take place after the initial closing.

Due to the fact deed-in-lieu transactions are more prone to challenge and dangers as outlined above, any title insurer releasing an owner's policy is most likely to carry out a more extensive evaluation of the transaction during the underwriting procedure than they would in a typical third-party purchase and sale transaction. The title insurance company will scrutinize the celebrations and the deed-in-lieu files in order to recognize and alleviate dangers provided by problems such as merger, blocking, recharacterization and insolvency, consequently potentially increasing the time and expenses associated with closing the deal, however eventually supplying the lending institution with a higher level of security than the loan provider would have missing the title company's participation.
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Ultimately, whether a deed-in-lieu deal is a feasible option for a loan provider is driven by the particular facts and situations of not just the loan and the residential or commercial property, but the parties included too. Under the right set of situations, therefore long as the correct due diligence and documentation is gotten, a deed in lieu can provide the lending institution with a more effective and cheaper 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 require 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.