When a commercial mortgage lender sets out to implement a mortgage loan following a debtor default, a crucial objective is to recognize the most expeditious way in which the lender can acquire control and ownership of the underlying security. Under the right set of situations, a deed in lieu of foreclosure can be a much faster and more affordable alternative to the long and protracted foreclosure process. This article goes over actions and concerns lenders should consider when deciding to continue with a deed in lieu of foreclosure and how to prevent unexpected risks and challenges throughout and following the deed-in-lieu procedure.

Consideration

An essential component of any agreement is ensuring there is adequate consideration. In a basic transaction, factor to consider can easily be developed through the purchase rate, however in a deed-in-lieu scenario, verifying adequate factor to consider is not as uncomplicated.

In a deed-in-lieu circumstance, the quantity of the underlying debt that is being forgiven by the lending institution normally is the basis for the factor to consider, and in order for such consideration to be considered "appropriate," the debt needs to a minimum of equal or exceed the fair market price of the subject residential or commercial property. It is essential that loan providers get an independent third-party appraisal to substantiate the worth of the residential or commercial property in relation to the quantity of debt being forgiven. In addition, its suggested the deed-in-lieu agreement include the customer's express recognition of the reasonable market worth 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 consideration.

Clogging and Recharacterization Issues

Clogging is shorthand for a principal rooted in ancient English common law that a borrower who secures a loan with a mortgage on realty holds an unqualified right to redeem that residential or commercial property from the loan provider by paying back the debt up until the point when the right of redemption is legally snuffed out through a proper foreclosure. Preserving the borrower's equitable 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 preclude a debtor's equitable right of redemption, however, steps can be required to structure them to restrict or prevent the danger of a blocking challenge. Primarily, the reflection of the transfer of the residential or commercial property in lieu of a foreclosure need to occur post-default and can not be pondered by the underlying loan documents. Parties ought to likewise 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 maintains rights to the residential or commercial property, either as a residential or commercial property manager, a renter or through repurchase options, as any of these arrangements can develop a threat of the deal being recharacterized as an equitable mortgage.

Steps can be taken to reduce versus recharacterization risks. Some examples: if a borrower's residential or commercial property management functions are limited to ministerial functions rather than substantive choice making, if a lease-back is brief term and the payments are clearly structured as market-rate usage and tenancy 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 advised that deed-in-lieu agreements include the parties' clear and unequivocal 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 secured by a mortgage on property, it holds an interest in the real estate by virtue of being the mortgagee under a mortgage (or a beneficiary under a deed of trust). If the loan provider then obtains the property from a defaulting mortgagor, it now likewise holds an interest in the residential or commercial property by virtue of being the charge owner and acquiring the mortgagor's equity of redemption.

The basic rule on this problem 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 fee takes place in the absence of evidence of a contrary intention. Accordingly, when structuring and documenting a deed in lieu of foreclosure, it is necessary the contract plainly shows the celebrations' intent to maintain the mortgage lien estate as distinct from the charge so the lending institution maintains the capability to foreclose the underlying mortgage if there are stepping in liens. If the estates combine, then the lending institution's mortgage lien is snuffed out and the loan provider loses the ability to deal with stepping in liens by foreclosure, which could leave the lending institution in a possibly even worse position than if the lender pursued a foreclosure from the start.

In order to plainly reflect the celebrations' intent on this point, the deed-in-lieu arrangement (and the deed itself) must consist of express anti-merger language. Moreover, since there can be no mortgage without a debt, it is popular in a deed-in-lieu circumstance for the lender to provide a covenant not to take legal action against, rather than a straight-forward release of the debt. The covenant not to sue furnishes factor to consider for the deed in lieu, safeguards the borrower versus direct exposure from the financial obligation and also retains the lien of the mortgage, therefore allowing the loan provider to keep the capability to foreclose, needs to it end up being desirable to eliminate 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 deals can be a substantial sticking point. While the majority of states make the payment of transfer tax a seller commitment, as a practical matter, the lender ends up absorbing the cost considering that the customer is in a default situation and normally lacks 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 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 approximately the quantity of the debt. 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 restricted only to a transfer of the borrower's personal residence.

For an industrial deal, the tax will be calculated based upon the complete purchase rate, which is specifically defined as consisting of the amount of liability which is assumed or to which the real estate is subject. Similarly, however a lot more possibly extreme, New york city bases the amount of the transfer tax on "consideration," which is defined as the unpaid balance of the debt, plus the overall quantity of any other enduring liens and any amounts paid by the beneficiary (although if the loan is option, the factor to consider is topped at the reasonable market price of the residential or commercial property plus other amounts paid). Remembering the lender will, in the majority of jurisdictions, need to pay this tax once again when ultimately offering the residential or commercial property, the particular jurisdiction's guidelines on transfer tax can be a determinative factor in choosing whether a deed-in-lieu deal is a feasible option.

Bankruptcy Issues

A major concern for loan providers when identifying if a deed in lieu is a viable option is the concern that if the borrower becomes a debtor in a personal bankruptcy case after the deed in lieu is complete, the bankruptcy 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 squarely within subsection (b)( 2) of Section 547 of the Bankruptcy Code dealing with preferential transfers. Accordingly, if the transfer was made when the debtor was insolvent (or the transfer rendered the debtor insolvent) and within the 90-day duration set forth in the Bankruptcy Code, the borrower ends up being a debtor in a 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 a bankruptcy 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, became insolvent due to the fact that of the transfer, was taken part in a business that maintained an unreasonably low level of capital or intended to incur debts beyond its capability to pay. In order to alleviate against these risks, a loan provider should thoroughly evaluate and evaluate the customer's financial condition and liabilities and, ideally, require audited monetary statements to verify the solvency status of the debtor. Moreover, the deed-in-lieu contract must consist of representations as to solvency and a covenant from the debtor not to apply for bankruptcy throughout the choice period.

This is yet another factor why it is crucial for a lender to procure an appraisal to confirm the value of the residential or commercial property in relation to the debt. A present appraisal will help the lender 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, the majority of owners and their lending institutions will get policies of title insurance to secure their respective interests. A lending institution considering taking title to a residential or commercial property by virtue of a deed in lieu may ask whether it can count on its loan provider's policy when it becomes the cost owner. Coverage under a lender's policy of title insurance can continue after the acquisition of title if title is taken by the same entity that is the called insured under the loan provider's policy.

Since many lending institutions prefer to have title vested in a different affiliate entity, in order to ensure ongoing protection under the lender's policy, the called lender must appoint the mortgage to the designated affiliate title holder prior to, or simultaneously with, the transfer of the charge. In the option, 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 trigger transfer tax liability).

Notwithstanding the continuation in protection, a lending institution's policy does not transform 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 lending institution's policy would not provide the same or a sufficient level of defense. Moreover, a lending institution's policy does not obtain any security for matters which emerge after the date of the mortgage loan, leaving the lending institution exposed to any issues or claims stemming from occasions which take place after the original closing.

Due to the reality deed-in-lieu transactions are more prone to challenge and dangers as laid out above, any title insurance company providing an owner's policy is likely to carry out a more strenuous evaluation of the transaction throughout the underwriting process than they would in a common third-party purchase and sale deal. The title insurance company will inspect the parties and the deed-in-lieu files in order to determine and alleviate risks provided by concerns such as merger, obstructing, recharacterization and insolvency, therefore potentially increasing the time and expenses associated with closing the transaction, however ultimately providing the lender with a higher level of security than the lender would have missing the title business's involvement.
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Ultimately, whether a deed-in-lieu deal is a practical alternative for a lending institution is driven by the specific realities and circumstances of not just the loan and the residential or commercial property, however the celebrations involved too. Under the right set of circumstances, and so long as the correct due diligence and documentation is acquired, a deed in lieu can offer the lender with a more effective and less costly methods 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 connect to attorney Meghan A. Hayden at (203) 772-7775 and mhayden@harrisbeachmurtha.com, or the Harris Beach attorney with whom you most regularly work.